Commission staff working document accompanying document to the Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the Committee of the Regions and the European Central Bank Five years of an enlarged EU - Economic achievements and challenges - Hoofdinhoud

COUNCIL OF Brussels, 24 February 2009 THE EUROPEAN UNION

6842/09 ADD 1

ECOFIN 152 UEM 60 AG 19

COVER NOTE

from: Secretary-General of the European Commission,

signed by Mr Jordi AYET PUIGARNAU, Director

date of receipt: 20 February 2009

to: Mr Javier SOLANA, Secretary-General/High Representative

Subject: Commission staff working document accompanying document to the

Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the Committee of the Regions and the European Central Bank

Five years of an enlarged EU

– Economic achievements and challenges

Delegations will find attached Commission document SEC(2009) 177.

________________________

Encl.: SEC(2009) 177

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 20.2.2009 SEC(2009) 177

COMMISSION STAFF WORKING DOCUMENT

Accompanying document to the

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE, THE COMMITTEE OF THE REGIONS AND THE EUROPEAN

CENTRAL BANK

Five years of an enlarged EU – Economic achievements and challenges –

{COM(2009) 79 final i}

EN EN

COMMISSION STAFF WORKING DOCUMENT

Accompanying document to the

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE, THE COMMITTEE OF THE REGIONS AND THE EUROPEAN

CENTRAL BANK

Five years of an enlarged EU – Economic achievements and challenges –

{COM(2009) 79 final i}

EN EN

European Commission

Directorate-General for Economic and Financial Affairs

Five years of an enlarged EU

Economic achievements and challenges

EUROPEAN ECONOMY 1/2009

ABBREVIATIONS AND SYMBOLS USED

Member States

BE Belgium

BG Bulgaria

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

EL Greece

ES Spain

FR France

IE Ireland

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL The Netherlands

AT Austria

PL Poland

PT Portugal

RO Romania

SI Slovenia

SK Slovakia

FI Finland

SE Sweden

UK United Kingdom

Other countries

BR Brunei

HK Hong-Kong

ID Indonesia

KR South Korea

MY Malaysia

PH The Philippines

SG Singapore

TH Thailand

TW Taiwan

EA Euro area

EA-15 European Union, Member States having adopted the single currency

(BE, DE, EL, ES, FR, IE, IT, CY, LU, MT, NL, AT, PT, SI and FI) EU-10 European Union, Member States that joined the EU on 1 May 2004

(CZ, EE, CY, LT, LV, HU, MT, PL, SI and SK) EU-12 EU-10 plus Member States that joined the EU on 1 January 2007 (BG, RO) EU-15 European Union, 15 Member States before 1 May 2004

(BE, DK, DE, EL, ES, FR, IE, IT, LU, NL, AT, PT, FI, SE and UK) EU-25 European Union, 25 Member States before 1 January 2007

EU-27 European Union, 27 Member States

Currencies

EUR euro

BGN New Bulgarian lev

CZK Czech koruna

DKK Danish krone

EEK Estonian kroon

GBP Pound sterling

HUF Hungarian forint

JPY Japanese yen

LTL Lithuanian litas

LVL Latvian lats

PLN New Polish złoty

RON New Romanian leu

SEK Swedish krona

SKK Slovak koruna

USD US dollar

Other abbreviations

ALMPs Active Labour Market Policies

ASEAN Association of Southeast Asian Nations

BEPG Broad Economic Policy Guidelines

BIS Bank for International Settlements

Bn. Billion

CAP Common Agricultural Policy

CESR Committee of European Securities Regulators

CF Cohesion Fund

CIS Commonwealth of Independent States

EAFRD European Agricultural Fund for Rural Development

EAGF European Agricultural Guarantee Fund

EBRD European Bank for Reconstruction and Development

ECB European Central Bank

ECOFIN European Council of Economics and Finance Ministers

EDP Excessive deficit procedure

EFF European Fisheries Fund

EMU Economic and monetary union

ERDF European Regional Development Fund

ERM II Exchange Rate Mechanism, mark II

ESCB European System of Central Banks

ESF European Social Fund

EU European Union

Eurostat Statistical Office of the European Communities

FDI Foreign direct investment

FSAP Financial Services Action Plan

GDP Gross domestic product

GNI Gross National Income

HICP Harmonised index of consumer prices

ICT Information and communications technology

IMF International Monetary Fund

IP Industrial Production

ISPA Instrument for Structural Policies for Pre-Accession lhs Left hand side

M&A Mergers and Acquisitions

Mio. Million

MENA Middle East and Northern Africa

MTO Medium-term budgetary objective

NAWRU Non accelerating wage inflation rate of unemployment

NEER Nominal effective exchange rate

NMS New Member States

NUTS Nomenclature of Territorial Units for Statistics

OCA Optimum currency area

OMS Old Member States

PHARE Poland and Hungary: Assistance for Restructuring their Economies

PPS Purchasing Power Standard

R&D Research and development

REER Real effective exchange rate rhs Right hand side

RoW Rest of the World

SAPARD Special Accession Programme for Agriculture and Rural Development SE Asia Southeast Asia

SGP Stability and Growth Pact

SITC Standard International Trade Classification

TFP Total factor productivity

UN United Nations

ULC Unit labour costs

USSR Union of Soviet Socialist Republics

VA Value added

VAT Value added tax

WTO World Trade Organisation

Legend to tables

• : 

  Figures are neglible

(figure) Figure of limited reliability na Not available

ACKNOWLEDGEMENTS

This report resulted from the collaboration of several Commission services. It was prepared under the responsibility of a Steering Board consisting of Marco Buti (Director General of the Directorate General of Economic and Financial Affairs), Michael Leigh (Director General Enlargement) and Vitor Gaspar (acting Director General Bureau of European Policy Advisers).

A Coordination Committee assisted in the steering of the project with the following members: Jost Angerer (Directorate-General Enterprise and Industry), Tom Diderich (Directorate-General Internal Market and Services), Filip Keereman (Directorate-General Economic and Financial Affairs), Radek Malý (Directorate-General Employment, Social Affairs and Equal Opportunities), Lars Nilsson (Directorate-General Trade), István Pal Székely (Directorate-General Economic and Financial Affairs), Axel Wallden (Directorate-General Enlargement).

Filip Keereman and István Pal Székely, both of the Directorate-General Economic and Financial Affairs, did the overall management of the project.

The main contributors to the report were Siegfried Steinlein (ECFIN), Mihai-Gheorghe Macovei (ECFIN), Anton Jevčák (ECFIN), Balázs Párkányi (ECFIN), Corina Weidinger Sosdean (ECFIN), Christian Just (ECFIN), Guy Lejeune (ECFIN), Malgorzata Galar (ECFIN), Jost Angerer (ENTR), Aleksander Rutkowski (ECFIN), Nikolay Gertchev (ECFIN), Alfonso Arpaia (ECFIN), Christoph Maier (EMPL), Christian Gayer (ECFIN), Dominique Simonis (ECFIN), Alexandr Hobza (ECFIN), Lorena Ionita (ECFIN), Roland Eisenberg (ECFIN), Zdeněk Čech (ECFIN), Paul Kutos (ECFIN), Stefaan Pauwels (ECFIN) and Rafal Raciborski (ECFIN).

Specific contributions were provided by Rainer Wichern (ECFIN), Manuel Palazuelos Martinez (ECFIN), Anna Melich (BEPA), Lars Nilsson (TRADE), Norbert Sagstetter (SG), Uwe Böwer (ECFIN), Alessandro Turrini (ECFIN), Julia Lendvai (ECFIN), Constantin Tudor (ENTR), Heinz Jansen (ECFIN), Katarzyna Wilk (BEPA), Jakub Wtorek (EMPL), Michael Grams (ECFIN), Jan in’t Veld (ECFIN), Janos Varga (ECFIN), Christian Buelens (ECFIN), Olivia Galgau (ECFIN), Barbara Moench (ECFIN).

Particular chapters or sections in the report received guidance from Jan Truszczynski (ELARG), Maurice Guyader (ELARG), Tassos Belessiotis (BEPA), Heliodoro Temprano Arroyo (ECFIN), Siegfried Steinlein (ECFIN), Karl Pichelmann (ECFIN), Radek Malý, (EMPL), Peter Weiss (ECFIN), Fabienne Ilzkovitz (ECFIN), Declan Costello (ECFIN), Lucio Pench (ECFIN), Massimo Suardi (ECFIN), Mark Hayden (ECFIN).

The report benefited from an extensive review by Oliver Dieckmann (ECFIN). A language check was provided by David Crowther and colleagues (DGT), as well as by Sophie Bland (ECFIN).

The lay-out of the report was in the capable hands of Rajko Vodovnik, Mariola Przygoda and Martine Maebe.

Comments on the report would be gratefully received and should be sent by mail or e-mail to:

Filip Keereman

István Pal Székely

European Commission

Directorate-General of Economic and Financial Affairs

Office BU5 2-166

B-1049 Brussels e-mail: filip.keereman@ec.europa.eu ; istvan-pal.szekely@ec.europa.eu

CONTENTS

Communication from the Commission 1

Chapter I: Introduction 5

Chapter II: Five years in the EU: achievements and experiences 9

Summary of main findings 11 1. Enlargement and the EU in the world 13

1.1. Milestones of the fifth Enlargement 13 1.2. Expectations regarding the fifth enlargement 15 1.3. EU economic governance 16

1.4. Challenges and opportunities for the new and old Member States and the EU as a whole 17

1.5. The enlarged EU in the global economy 19 1.6. An enhanced international role 21

• 2. 

  Economic performance in an enlarged EU 24

2.1. Ex-ante estimates of the economic impact of enlargement 24 2.2. Closing the income gap 26 2.3. The quality of the catching-up 28

2.4. Economic Integration and macroeconomic stability: the underlying conditions for growth 31

• 3. 

  Does the EU make a difference? 38

3.1. Economic integration in Asia 38 3.2. Catching-up in the new Member states and Asia 40 3.3. Similarities and differences in the growth model 42 3.4. Conclusion 47

Chapter III: Goods and services in an enlarged EU 49

Summary of main findings 51 1. Trade and catching-up 53

1.1. Trade and growth 53 1.2. Competitiveness 55 1.3. Geographical composition 56 1.4. Product composition 60

• 2. 

  The functioning of the product markets in the recently

acceded Member States 66

2.1. Shift towards a knowledge society 66 2.2. Overall evolution of competition 68 2.3. General governance of competition and regulatory policies 70 2.4. State aid 71 2.5. Competition in specific sectors 72

Chapter IV: Capital markets in an enlarged EU 79

Summary of main findings 81 1. Foreign direct investment and catching-up 83

1.1. The role of FDI in enhancing the growth potential of the host economies 83

1.2. Factors which drive FDI in the EU 87 1.3. Possible relocation of production capacity and jobs 89 1.4. The sectoral and regional dimensions 94

• 2. 

  Financial integration and financial sector development 98

2.1. Financial sector development and integration 98 2.2. Challenges of financial integration and development 104

Chapter V: The free movement of labour in an enlarged EU 111

Summary of main findings 113 1. Changing labour market patterns in the enlarged European Union 114

1.1. Better labour market performance in the old Member States 114 1.2. Labour markets in the new Member States 115

• 2. 

  The opening of the borders and mobility 122

2.1. Transitional arrangements for the free movement of workers 122 2.2. Extent of intra-EU mobility after enlargement 122 2.3. Main characteristics of intra-EU movers 127 2.4. The impact of recent intra-EU migration 129

2.5. Summary and conclusions 132

Chapter VI: Integrating in the EU or in the world? 135

Summary of main findings 137

• 1. 

  Economic integration, structural similarity and specialisation 138 2. Business cycle synchronisation between new and old Member States: the empirical picture 141 3. Estimating the relationship between synchronisation and economic integration 147 4. Summary and conclusions 148

Chapter VII: Enlargement and the EU policy framework 151

Summary of main findings 153 1. The Single Market 156

1.1. Main lessons from the Single Market Review 156 1.2. Degree of implementation of the Single Market in the new Member States 158 1.3. Impact of enlargement on the Single Market 160

• 2. 

  The Lisbon strategy for growth and jobs 165

2.1. New Member states and structural reform 165 2.2. LIsbon strategy and new Member states 169

2.3. The reform priorities in the new and old Member states 171 2.4. Progress since the relaunch of the strategy 175

2.5. Conclusions 175

• 3. 

  Fiscal surveillance 177

3.1. Recent fiscal performance 177 3.2. Safeguarding macro-financial stability 179

3.3. Public investment and the quality of public finances 181

• 4. 

  Economic and Monetary Union 186

4.1. Monetary and exchange rate arrangements in the "pre-ins" 186 4.2. Progress in nominal convergence: 5 years on 187 4.3. Challenges of the euro convergence process 191

4.4. Conclusions 195

• 5. 

  The role of EU transfers 196

5.1. Types and volumes of EU transfers 196 5.2. Regional and cohesion policy 199

5.3. Common Agricultural Policy 204

References 207

LIST OF TABLES

II.1.1. The enlarged EU in the global economy, 2007 21 II.2.1. Estimation results for beta-convergence in EU-27 27 II.2.2. GDP growth and its main components 29 II.2.3. Sectoral contributions to growth 29 II.2.4. Sectoral contribution to growth in selected regions 30 II.2.5. Production factors' contribution to growth 30 II.2.6. Investment by asset type 31 II.2.7. Trade patterns in the enlarged EU 32 III.1.1. Average growth rates of trade volumes per region 53 III.1.2. Export market shares of new and old Member States 57 III.1.3. Geographical destination of exports of new Member States 58 III.1.4. Geographical destination of exports of old Member States 59 III.1.5. Breakdown of total exports by factor intensity 61 III.1.6. Breakdown of manufacturing exports by technology intensity 62 III.1.7. Export quality as measured by unit value ratios 65 III.2.1. Total state aid 71 III.2.2. State aid: sectoral and horizontal objectives 72

IV.1.1. Correlation of average employment in manufacturing enterprises in the old and the new Member States, 1998-2007 93

IV.2.1. Quality of institutions in the new Member States and in other developing countries, 1999-2008 104

IV.2.2. Financial soundness indicators for the new Member States in 2004 and 2007 107

IV.2.3. Fitch approach on banking system soundness for the new Member States in 2005 and 2008 108

V.2.1. Member States' policies towards workers from the new Member States 123 V.2.2. Main EU destination countries of recent intra-EU movers, 2007 125

V.2.3. Employment by economic activity of recent movers from new to old Member States, 2007 129

V.2.4. Employment by skills of recent movers from new to old Member States, 2007 129

V.2.5. Medium-term economic effects of recent intra-EU mobility flows on receiving and sending Member States 131

VI.1. Output composition in nominal terms 139 VI.2. Output composition in real terms 140

VI.3. Business cycle correlation: new Member States with old Member States aggregate 142

VI.4. Business cycle correlation: new Member States with the US 143 VI.5. Leads and lags of new Member States' business cycles versus old Member States and the US 144 VI.6. Volatility of new Member States' cycles 144 VI.7. Persistence of cycles in the new Member States 145 VI.8. Correlation of expenditure components in new Member States with old Member states 146 VI.9. Correlation of sectoral output cycles in new Member States with old Member states 147 VI.10. Determinants of synchronisation: model results 148 VII.1.1. Mergers and acquisitions in the new and old Member States classified by region of bidding firm, 2000-2007 161 VII.1.2. Sectoral classification of mergers and acquisitions in old and new Member States, 1998-2007 162 VII.2.1. Evidence on post-enlargement reform fatigue form different reform indicators 167 VII.3.1. Budget balances in the new Member States 178 VII.3.2. Volatility in fiscal variables, 2004-2008 180 VII.3.3. Growth and the quality of public finances: selected indicators for the EU Member States, 2004-08 182 VII.4.1. Monetary policy regimes in the new Member States 187 VII.5.1. Absorption rates in programming period 2000-2006 201

LIST OF GRAPHS

II.1.1. Support for enlargement, Autumn 2002 15 II.1.2. Opinions on enlargement 16 II.1.3. The EU after enlargement in perspective 20 II.2.1. Per capita GDP in the EU 26 II.2.2. Sigma-convergence in the EU 27 II.2.3. Regional disparities and per capita GDP in 1995-2005 28 II.2.4. Inward FDI in the new and old Member States 32 II.2.5. Output gaps in the enlarged EU 32

II.2.6. FDI stocks in the new Member States and economic growth of selected old Member States 33

II.2.7. Trade with the new Member States and economic growth of the old Member States 33

II.2.8. Nominal convergence in the enlarged EU 36 II.2.9. Sacrifice ratios in the old and new Member States 36

II.3.1. Real GDP growth in selected Asian countries during and after the 1997 Asian crisis 42

II.3.2. Real GDP growth in the new Member States, 2007-2009 42 II.3.3. Catching-up in the new Member States and Southeast Asia, 1999-2008 42

II.3.4. Real GDP growth and its composition in the new Member States and Southeast Asia, 2003-2007 43

II.3.5. Savings and investment in the new Member States and Southeast Asia 44 II.3.6. Intra-regional trade in the new Member States and Southeast Asia 44

II.3.7. Bertelsmann Transformation Index for the new Member States and Southeast Asia 46

III.1.1. The importance of intra and extra-EU trade in goods for new and old Member States 54

III.1.2. Member States' openness ratios and real GDP growth, 1996-2007 55 III.1.3. Real effective exchange rates and their components 56 III.1.4. Export market share after EU accession (extra-EU) 57 III.1.5. Shifts of export destinations from a single old Member State, 1999-2007 58 III.1.6. Shifts of export destinations from a single new Member State, 1999-2007 59 III.1.7. Trade balance of old Member States in 1999-2007 60 III.1.8. Trade balance of new Member States in 1999-2007 60 III.1.9. New Member States: export market share by factor intensity 63 III.1.10. Old Member States: export market share by factor intensity 63 III.1.11. New Member States: export market share by technology intensity 63 III.1.12. Old Member States: export market share by technology intensity 64 III.2.1. Employment in high-tech manufacturing and knowledge-intensive hightechnology

services 66 III.2.2. Exports of high technology products 66 III.2.3. The European Innovation Scoreboard 67 III.2.4. European Patent Office applications 67 III.2.5. Tertiary graduates in science and technology 68 III.2.6. Perceived development of competition 69 III.2.7. Incidence and change of business constraints 69 IV.1.1. Importance of inward FDI in host economy investment 84 IV.1.2. The role of services in foreign direct investment in the EU 86 IV.1.3. Inward FDI in the new Member States according to its origin 87 IV.1.4. Inward FDI in the new Member States and possible macroeconomic

factors of relocation 88 IV.1.5. The ease of doing business and FDI in the EU Member States 89 IV.1.6. Intermediate imports by old Member States from selected country

groups 93 IV.1.7. Domestic demand in the old Member States and income from FDI in the

new Member States 94 IV.1.8. The sectoral concentration of inward FDI 95 IV.1.9. The FDI stock and regional GDP dispersion in the EU 96 IV.2.1. Structure of financial markets in the Member States, 2008 98 IV.2.2. Total bank credit to the non-financial private sector 100 IV.2.3. Concentration of the banking sector in the new Member States, 2001-

2007 100 IV.2.4. Foreign ownership in the banking sector in the new Member States 100 IV.2.5. Stock market liquidity, 2000-2007 101 IV.2.6. Structure of the debt securities markets, 2006 101 IV.2.7. Distribution of total financial assets, 2007 101 IV.2.8. Lending and deposit rate spreads, 1998-2008 102 IV.2.9. Convergence of interest rates, 1999-2008 102 IV.2.10. External assets and liabilities of the new Member States, 2000-2007 102 IV.2.11. Loans to private sector in 2004 and 2008 105 IV.2.12. Loans to households by purpose in 2004 and 2008 106 IV.2.13. Foreign currency denominated loans to households and corporations in

2004 and 2007 106 IV.2.14. External loans of BIS reporting banks in 2004 and 2008 106 IV.2.15. Claims of selected old Member States on new Member States, 2004-

2008 107 IV.2.16. Private savings/investment balance and net lending/borrowing in 2004

and 2008 108 IV.2.17. Private consumption and private investment in 2004 and 2008 109 V.1.1. Harmonised unemployment rates in the EU, 2000 and 2007 115 V.1.2. Employment and GDP growth 116 V.1.3. Labour market performance in the old Member States, 1995-2007 117 V.1.4. Labour market performance in the new Member States, 1990-2007 118 V.1.5. Overall employment rates in the new Member States 119 V.1.6. Employment by age and skill level 119 V.1.7. Job vacancy rate in the new Member States, 2005 and 2007 120 V.1.8. Nominal unit labour costs and its components 121 V.2.1. Nationality of recent intra-EU movers, 2007 123 V.2.2. Recent intra and extra EU movers and the resident population 125 V.2.3. Mobility rates by sending country, 2007 126 V.2.4. Inflow of workers from the new Member States to the UK 126 V.2.5. Inflow of workers from the new Member States to Ireland 127 V.2.6. Socio-economic breakdown of recent movers from new Member States

to old Member States 128 V.2.7. Educational attainment of recent movers, 2006 128 V.2.8. Workers' remittances (incl. compensation of employees), 2006 131 VI.1. Trade specialisation 140 VI.2. Average rolling business cycle correlations between old and new

Member States 143 VI.3. Individual rolling business cycle correlations between old and new

Member States 143 VI.4. Rolling correlations of demand components in new and old Member

States 145 VI.5. Rolling correlations of sectoral output in new and old Member States 147 VII.1.1. Market integration in the new Member States 157 VII.1.2. Transposition deficit 159 VII.1.3. Value of public procurement which is openly advertised 160 VII.1.4. Price convergence between EU Member States 162 VII.1.5. Price convergence: Comparative changes in price levels over time,

1996-2007 163 VII.2.1. Fraser index of regulation in product, labour and financial markets 166 VII.2.2. Share of Member States underperforming in a policy area 171 VII.2.3. Policies in the employment and micro pillar 174 VII.2.4. Clusters of countries: performance in policy areas 174 VII.2.5. Progress in Lisbon strategy: average scores for a set of headline

indicators 175 VII.3.1. Structural budget balances in the new Member States 179 VII.3.2. Public investment, 2004-08 181 VII.3.3. Public debt, 2004-08 182 VII.4.1. Inflation criterion in the new Member States 189 VII.4.2. General government balance and debt in the new Member States 189 VII.4.3. Euro exchange rates of the new Member States 190 VII.4.4. The interest rate criterion in the new Member States 190 VII.4.5. Catching-up and price level convergence in the new Member States 193 VII.4.6. Income and price level convergence at euro entry in convergence

countries 193 VII.4.7. Sovereign debt ratings in the new Member States, 2000-2008 194 VII.4.8. Real short-term interest rates in the new Member States 195 VII.5.1. Total transfers to the Member States in 2007 197 VII.5.2. Regional distribution of EU transfers, 2007-2013 198 VII.5.3. Phasing-in of funds in the area of cohesion for growth and jobs 198 VII.5.4. EU budget expenditure for direct payments and rural development in

the new Member States, 2007-2013 198 VII.5.5. Net EU transfers and GDP per capita in 2007 199 VII.5.6. Structural funds (ERDF and ESF): absorption in 2004-2008 202 VII.5.7. Real agricultural income development in selected Member States,

2000-2007 205

LIST OF BOXES

II.1.1. Europe Agreements and a common trade policy 14 II.1.2. Cooperation and Verification Mechanism with Bulgaria and Romania 18

II.2.1. Pre-enlargement empirical studies on the potential economic impact of enlargement 25

II.2.2. Did EU accession contribute to growth? 34 II.2.3. The impact of a decrease in external spreads 37 II.3.1. Regionalism in Asia 39 II.3.2. Lessons from the Asian crisis for the new Member States 41 IV.1.1. Inward FDI and potential GDP growth in the EU 85 IV.1.2. Enlargement and the German economy 91 IV.2.1. Impact of the global financial crisis on the new Member States 99

V.2.1. The principle of free movement of workers and transitional

arrangements 124

VII.1.1. Examining price convergence in the enlarged Single Market 164

VII.2.1. Was there a reform fatigue in the new Member States after

enlargement? 168

VII.2.2. An assessment framework for structural reforms 173

VII.3.1. Reforms of pension systems in the new Member States 184

VII.4.1. Euro adoption plans of the new Member States 188

VII.4.2. The theory of Optimum Currency Areas and the new Member States 192

VII.5.1. Growth impact of EU support - an assessment with the QUEST model 203

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL, THE EUROPEAN PARLIAMENT, THE EUROPEAN ECONOMIC AND SOCIAL

COMMITTEE, THE COMMITTEE OF THE REGIONS AND THE

EUROPEAN CENTRAL BANK

Five years of and enlarged EU

– Economic achievements and challenges –

Adopted by the College on 18 February 2009

Five years of an enlarged EU

– Economic achievements and challenges – Chapter I

Introduction

INTRODUCTION

The fifth wave of enlargement was a historic step enlargement round. The advantages of inclusion, in the reunification of Europe. With ten countries a wider Europe and increased market access will acceding in 2004 and further two in 2007, this need to be balanced against the costs and enlargement round of the EU was the largest, in challenges of adjustment. Special attention will terms of both the number of countries and be paid to the role of multilateral surveillance population. Most relevant feature was that it which the EU can offer in policy formulation. brought together countries which had Policy lessons will also be learned on the basis of experienced very different economic, social and the experience gathered so far. The report builds political developments. It was a milestone in on an earlier assessment and accompanying unifying Europe after several decades of artificial Communication from the Commission entitled division resulting from the Cold War. Overall, "Enlargement, Two Years After – An Economic this enlargement was a major success for the EU Success" (European Commission, 2006). and its citizens.

The study specifically responds to an initiative of The new Member States – through their sheer the Czech authorities to make an event out of number and dynamism – have made the EU five years enlargement during their Presidency in stronger and culturally richer. The enlargement the first half of 2009. While the impact of process has helped build and consolidate enlargement in its geo-political or cultural democracy after the demise of the communist dimensions is difficult to underestimate, the main regimes. It has strengthened European security, focus will be on economic aspects, while also by providing a crucial anchor of stability in a including broader issues such as employment, period of conflicts and upheavals within and the free movement of persons and competition as around Europe. It has greatly boosted the well as the role of institutions in economic economies and improved living standards in the development. new Member States, thereby also benefiting the old member states notably through new export Enlargement is studied from three perspectives. and investment opportunities. It has strengthened The first of these is the impact of enlargement on the economy of the Union as a whole, through the EU as a whole and its place in the global the advantages of integration in a larger internal economy. The EU is more than the sum of its market. Enlargement has also enabled the EU to component parts and this study analyses how reap more fully the benefits of globalisation. An enlargement has helped the EU to come up with enlarged EU has more weight when addressing a response to globalisation. Second, the focus is issues such as the world climate change or the on the recently acceded Member States, in international financial crisis. particular on how they have integrated into the

EU, what are the drivers of the catching-up The integration process raised many doubts, process and how the EU has contributed to their including concerns about the capacity of the EU development. Third, the impact on the old institutions to absorb the wider variety of Member States is assessed, more especially in opinions that would have to be taken into terms of how the old Member States benefited account in the decision-making process. from gaining access to a larger market, but also Questions were raised about the costs of the how they coped with the competitive pressure enlargement, as most of the newcomers had created by a number of low-cost countries significantly lower income levels than the joining the Single Market. In this context special average of the incumbent Member States. Not attention will be paid to the effects of migration surprisingly, EU citizens had mixed feelings and and offshoring on the labour market and wage saw risks in terms of their jobs, wages, security developments. and identity. The global financial crisis and economic slowdown is adding another dimension With respect to country coverage, the report which puts a strain on the integration and includes Romania and Bulgaria where possible. convergence already achieved. Usually, the EU-15 countries are used as a

benchmark, but often other reference points are Against this background, the aim of the present also included where relevant. The analysis report is to study the consequences of the latest focuses on the five-year period between 2004

Chapter I

Introduction

and 2008 and compares this with the previous Thus, the first section of Chapter 3 deals with five years. However, in many cases a longer trade and catching-up, while in the second time perspective is presented in order to section an assessment of the goods markets in the understand developments and gain the measure new Member States is made with the old of the anticipation effects. Member States as a benchmark. Chapter 4

examines the free movement of capital; first, the On 13 and 14 November 2008 the Directorate focus is on foreign direct investment and General for Economic and Financial Affairs in integration, then on financial sector co-operation with the Bureau of European Policy development. Chapter 5 analyses first the broad Advisers and the Directorate General for trends in labour markets followed by a Enlargement organised a workshop entitled "Five discussion of labour mobility. years of an enlarged EU – a positive sum game"

(for more information, see DG ECFIN's website, These three core chapters set the scene for past events). The purpose of that workshop was Chapter 6 which assesses the extent to which the to check the findings and main messages recently acceded countries are integrated into the emerging from the study in progress. At that EU as compared to the world at large by workshop, researchers from academia and think focusing on the synchronisation of business tanks presented their views on enlargement cycles. which were a source of inspiration for the final version of the report. Chapter 7 spells out the EU policy framework

and how it is affected by enlargement and how it The report is structured in 7 chapters, preceded is applied to the recently acceded Member States by an executive summary which has been as well as its contribution to their catching-up adopted by the Commission and issued as a process. Five sections deal with the key policy Communication. After this introductory chapter, areas: (i) the Single Market, (ii) the Lisbon Chapter 2 presents the achievements and process, (iii) fiscal surveillance, (iv) Economic experiences of five years of an enlarged EU in and Monetary Union and (v) the role of EU three sections. Each section is devoted to a transfers. particular dimension, namely: The enlarged EU in the world; Economic performance in an enlarged EU; and Does the EU make a difference?

Related to the motto of the Czech Presidency,

“Europe without barriers”, the report makes a link to the four freedoms (the free movement of goods, services, capital and persons) in an enlarged EU. This is done in Chapters 3, 4 and 5

(with the free movement of goods and services being covered in Chapter 3). These chapters analyse how the basic freedoms have operated in practice and how both the old and the recently acceded Member States have adjusted to them.

These three chapters deal with two recurrent themes: first, an analysis of the international dimension of the four freedoms with a focus on the drivers of integration and, second, an analysis of the consequences for the functioning of domestic markets with a focus on the role of restructuring, competitive pressure and adjustment.

Chapter II

Five years in the EU: achievements and

experiences

SUMMARY OF MAIN FINDINGS

The fifth enlargement was different from the labour shedding related to economic others as it was the largest in terms of the restructuring. In the 5 years after accession, number of acceding countries and the size of average GDP growth in the new Member States their population. Most importantly, on average amounted to 5½ %, compared with 3½ % in the the recently acceded countries had significantly preceding 5 years, while growth in the old lower levels of income than the average of the Member States remained at around 2¼ %. In line incumbent Member States compared to the with the global slowdown brought about by the countries that had joined the EU previously. It credit crisis in the US and rising energy and made the integration process a formidable commodity prices, activity weakened in 2008, challenge, for both the new and the old Member particularly in the Baltic States.

States, but at the same time provided notable opportunities for the individual countries and the Key drivers of the growth process in the new EU as a whole. Member States were trade openness, foreign

direct investment and an overall improvement in In order to prepare for such a major accession, the institutional framework to which accession the process officially started as early as 1993, contributed decisively. These factors led to an when the invitation to apply for membership was acceleration of productivity growth, which is the issued by the Copenhagen European Council basis for an enduring increase in the standard of which set out the so-called Copenhagen criteria. living.

These included conditions of an economic, political and legislative nature which had to be Based on growth regression analysis, it is met before membership could be considered. estimated that each year during the period 2000- Because of the challenges involved, citizens' 2008 accession gave the new Member States an support for enlargement in the EU-15 countries extra growth boost of around 1¾ % on average. has been mixed and volatile both before and after This compares favourably with the Commission the fifth wave of enlargement, in contrast to services' ex ante estimate in 2001 of 1.3% economic studies which generally came up with additional growth in a central scenario, but falls positive results. short of the 2.1 % proposed in the optimistic

scenario. Possible elements of the success were While the newly acceding Member States the productivity improvements due to FDI and accounted for about 21% of the EU population, the associated transfer of technology. Model they contributed only about 7% of GDP. As simulations suggest that the narrowing of the economic growth in the new Member States is interest rate spread was also of particular significantly stronger, the initial income gap importance. It appears that the new Member relative to the EU average is narrowing. States enjoy a 50-100 basis point advantage However, the benefits of the fifth enlargement relative to other emerging countries with are primarily not due to the slightly higher comparable fundamentals. This contributed overall weight of the EU-27 in world GDP (by 0.3 % of additional growth, although the new around 2.5 percentage points in purchasing Member States will no longer be able to count on power standards), but to the synergies and this in the near future, as risk premia have risen economic dynamism that this association of as a consequence of the outbreak of the financial Member States has made possible, enabling crisis in 2007. better answers to be formulated to address the challenges posed by globalisation. The stronger growth performance enabled the

new Member States to catch up in terms of GDP After a transition related recession in the early per capita from some 40 % of the EU-15 average nineties, the economies of the new Member five years before enlargement to 52% in 2008. States stabilised and received a boost to their The real convergence process in some countries growth in the second half of the nineties in the was faster than in others, highlighting the light of accession which had become a distinct importance of having the appropriate policies in possibility. Output growth accelerated further on place. Starting from low income levels, catching EU entry in 2004, accompanied by strong job up - supported mainly by a boom in demand - creation in most countries after several years of appeared particularly impressive in the Baltic

European Commission

Five years of an enlarged EU

States, but the overheating that followed has than others. This is due to the fact that capital been taking its toll since 2007. At the other and skilled labour tend to concentrate in a limited extreme, growth in Malta was not strong enough number of regions during the initial phase of the to close the relative income gap, underlining the catching-up process. When a certain stage of fact that catching-up cannot be taken for granted. development is reached, knowledge spill-overs Slovenia was one of the countries with the and the disadvantages of agglomeration (e.g. smoothest growth path. labour shortages) come to the fore and a more balanced income distribution is likely to be

Growth in the old Member States was about half achieved. that observed in the new Member States, with weak performances in some larger countries, but Real convergence went hand in hand with this cannot be attributed to enlargement. On the considerable progress in nominal convergence as contrary, the old Member States benefited from inflation rates, interest rates and government the growth pole formed by their neighbours. Ex deficits approached the levels that were being ante estimates made by the Commission in 2001 seen in the old Member States. However, from indicated an additional growth stimulus of 0.5 % mid-2007, as a consequence of the financial or 0.7 % at the end of the period examined, crisis, macro-financial stability came under namely 2009. These numbers could not be pressure in several new Member States with verified, but what is clear is that those EU-15 Hungary and Latvia asking for balance of countries with higher growth rates in their FDI payments support to overcome liquidity and trade activity with the new Member States constraints. This reassessment of risk in have also enjoyed larger increases in their real emerging markets, in turn, is leading to a per capita GDP growth rates. significant contraction in economic activity in many new Member States of some are likely to Per capita GDP growth in the new Member see, at least temporarily, a widening of the States since 2000 has been stronger than in some income gap with their richer neighbours in the emerging market economies in Southeast Asia EU. which are going through a similar catching-up process and are subject to the same global trends. This suggests that the EU context makes a difference as compared to the looser regional arrangements among the Southeast Asian countries. In particular, the EU had a favourable influence on the quality of institutions. Furthermore, EU membership helped overcome the lack of savings in the new Member States. This led to a catching-up model based on capital imports, that prompted current account deficits and appreciation of real exchange rates. However, the strengthening currency did not depress the export performance of the new Member States as inflows of foreign direct investment allowed a quality upgrade of the export basket. By contrast, since the 1997 financial crisis the catching-up approach practised by the Southeast Asian countries has relied on cheap currencies and current account surpluses.

On the whole, the relative income gap between countries is closing, but the distribution of the enlargement dividend within the countries is not proportional, with some regions benefiting more

• 1. 

  ENLARGEMENT AND THE EU IN THE WORLD

The fifth wave of enlargement was not only the has contributed to the widening of the continent's largest ever in terms of the number of countries prosperity.

and population joining the EU ( 1 ), but also the

most complex, as it brought in countries whose This chapter is structured as follows: Sections economic, social and political backgrounds had 1.1 and 1.2 present an overview of the milestones been very different. This round of enlargement of this wave of enlargement and the initial had a major impact on the EU as a whole and on expectations among the public and experts. its place in the global economy, and it is fair to Section 1.3 summarises the main characteristics say that it caused mixed reactions. While many of the EU’s economic governance system so as citizens welcomed the arrival of new members as to better understand the rationale for the a chance for Europe to become stronger, more Copenhagen economic criteria and the competitive and better able to defend its interests challenges associated with accession and on the world stage in the era of globalisation, transposition of the acquis. Section 1.4 goes a others saw it as a threat to their identity, their step further by highlighting the main challenges security, or their jobs. and opportunities deriving from enlargement for

both the new and the old Member States. Finally, The success of this endeavour needs to be judged sections 1.5 and 1.6 focus on the international against the background of the huge challenge of dimension of the enlargement process. reuniting Europe in the aftermath of the fall of the communist and socialist regimes in the East.

Given that - except for Cyprus and Malta - the 1.1. MILESTONES OF THE FIFTH aspiring EU members were former communist ENLARGEMENT and socialist countries with centrally-planned economies, some fundamental transformations As early as 1991, the EU signed the first “Europe were necessary that would allow these countries Agreements” with Hungary and Poland, followed to adopt the ‘acquis communautaire’ and by the other Central and Eastern European integrate into the EU's system of political and candidate countries. Cyprus and Malta had economic governance. That is why the accession already signed "Association Agreements" in the process officially started as early as 1993, when beginning of the 1970s. Thanks to these the Copenhagen European Council issued the agreements, trade was gradually liberalised, thus invitation to apply for membership. The avoiding any trade shocks in May 2004 and in European Council set out the "Copenhagen January 2007 (Box II.1.1). The overall economic criteria", which were the economic, political and integration of the candidate countries took place legislative criteria that applicants had to meet during the 1990s and early the following decade before membership could be considered. in a similar way, that is to say it was virtually Enlargement has conferred significant benefits completed by the dates of accession. on all parties involved by anchoring the economic and political life of the new Member Accession negotiations started officially in States. The EU represents a new model of March 1998 with six of the candidate countries cooperation and of economic organisation in a (the Czech Republic, Estonia, Hungary, Poland, union of sovereign states that share democratic Slovenia and Cyprus), and in October 1999 the values and adhere to the principles of a market negotiations were widened to include Bulgaria, based economy. Throughout the years, the EU Latvia, Lithuania, Malta, Romania and Slovakia. has fostered respect for a democratic and liberal The first ten acceding nations concluded the political culture based on the rule of law, and this accession negotiations by December 2002 and

signed the Accession Treaties in April 2003.

Negotiations with Bulgaria and Romania

continued for a further two years and were

( 1 ) On 1 May 2004, ten countries (Cyprus, Czech Republic,

Estonia, Hungary, Latvia, Lithuania, Malta, Poland, finalised by December 2004, allowing the

Slovakia and Slovenia) with around 75 million people Accession Treaties to be signed in April 2005.

joined the EU, followed on 1 January 2007 by two more Following the approval of the Treaties by each of

countries (Bulgaria and Romania) with their close to 30

million citizens. the acceding Member States and ratification in

European Commission

Five years of an enlarged EU

Box II.1.1: Europe Agreements and a common trade policy

The Europe Agreements had a political and Enlargement can be said to have led to more open economic motivation and were signed on bilateral world trade. The EU's most-favoured-nation basis. They were adapted to the specific situation tariffs are in general lower than those applied in of each partner state, while setting common the acceding countries and the EU had a vast political, economic and commercial objectives network of contractual or unilateral preferential and formed the framework for implementation of trading arrangements. For example, the EU's the necessary accession reforms. The trade average applied most-favoured-nation tariff of provisions of the Europe Agreements aimed to about 6.5% could compare favourably to that of establish, over a period of ten years, a bilateral around 11% in Slovenia in 2001 or 12% in free trade area between the EU and each country Bulgaria in 2003. Compared to the situation and dialogue modalities between governments before enlargement in 2004, today twelve more and community institutions. Consequently, at the countries apply the EU's Generalised System of date of accession, trade between the new Preferences, including the "Everything but Arms" members and the EU was already almost fully initiative which provides duty and quota free liberalised. access for all goods from least developed

As of the day of accession, the new Member countries (phase-in periods for certain products States started applying the EU’s Common will end in 2009). The same holds for the EU's Commercial Policy. This implied taking over all bilateral agreements with e.g. countries in the EU multilateral commitments and obligations Western Balkans, Chile, Mexico and South (including plurilateral agreements such as the Africa. The benefits of enlargement for third Government Procurement Agreement), bilateral countries lie in a single set of trade rules, a single agreements, the common external tariff tariff, and a single set of administrative (including unilateral preferences) and the EU procedures across the enlarged EU with a

trade defence measures. population close to 500 million people and a GDP of around €12,250 billion.

the EU Member States' legislatures, the official restrictions on the free movement of labour, have dates for enlargement were set for 1 May 2004 clearly interfered with the proper functioning of for the first ten new Member States and 1 the internal market. With respect to labour January 2007 for Bulgaria and Romania. Four of markets, the so-called "2+3+2 year arrangement" the new Member States have already joined the required the EU-15 states to declare in May euro area: Slovenia on 1 January 2007 and 2006, and again in May 2009, whether they will Cyprus and Malta one year later, while Slovakia open up their labour markets to workers from the was the fourth to join as of 1 January 2009. new Member States; there are exceptions for Cyprus and Malta, which are not part of the

Negotiations covered 31 chapters of the acquis scheme. and were particularly difficult and complex. A key principle in the negotiations was that no A significant area of the negotiations and of the permanent derogation from EU rules was to be accession process was concerned with financial accorded to the acceding nations. Because of the support for enlargement. The availability of EU technical and practical difficulties in making all funds – both a policy instrument and an the necessary adjustments and bearing the expression of EU solidarity - provides an adjustment costs, transitional periods ranging opportunity for the new Member States to from 6 months to 12 years were introduced prior improve competitiveness and strengthen the to the full adoption of the 'acquis catching-up process. Furthermore, upon communautaire'. The areas primarily concerned accession, Member States also benefit from are environment, agriculture, social and significant transfers in the area of agriculture and employment policies, transport, energy and the cohesion policy, as well as from a wide variety free movement of labour, services and capital. of programmes in different areas of EU policy. These transitional periods, and in particular the For the period 2004-2006, the December 2002

Chapter II

Five years in the EU: achievements and experiences

Copenhagen European Council adopted an enlargement for both the new and the old appropriation of €40.9bn for the ten acceding Member States (Box II.2.1 in the next section). nations (about 2.3% of their annual average Contrary to the positive findings of economic GDP). In the latest Financial Perspective, research, the initial expectations and perceptions covering the period 2007-2013, the amounts for of the public in relation to the perceived benefits the twelve new Member States have been of the fifth enlargement were mixed. increased to about 3% of their annual GDP.

While these amounts may be considered as a The citizens' support for enlargement in the EU- tolerable burden for the old Member States, from 15 countries was volatile both before and after the point of view of the recently acceded the fifth wave of enlargement. There has been Member States these are very considerable sums. evidence that the perception of enlargement is In 2007, about €17.8 billion were transferred to influenced not only by a sense of community and the new Member States, representing around affinity, but also by other, less altruistic motives 2.1% of EU-12 GDP and only 0.2% of the EU- where factors related to personal welfare and 15 GDP. Clearly, the extent to which the new well-being play an important role. A survey Member States will be able to utilise the leverage carried out in November 2002 (Graph II.1.1) potential of EU transfers in order to move onto a shows that public opinion in the EU-15 countries higher growth path in the long run will depend favoured enlargement to Malta, Cyprus and the on their absorption capacity and, in particular, on wealthier economies among the former the quality of their domestic policy environment. communist and socialist countries. In addition,

geographical and/or cultural proximity seemed to The accession of the new Member States had a play an important role, putting the more distant palpable impact on them, both before and after countries, such as Bulgaria and Romania, at a they joined the EU. The prospect of membership disadvantage. Also, the countries of the former spurred reforms and set a firm economic and Yugoslavia seemed to be relatively unknown to political course towards the fundamental liberal the public in the old Member States, as was and democratic values that are shared in the EU. confirmed, for example, by weaker support for These values were embodied in the Copenhagen Slovenia’s entry into the EU. criteria. After accession, both the new and incumbent Member States have experienced a Graph II.1.1: Support for enlargement, Autumn 2002 further reallocation of economic activities

resulting in significant benefits from a better Malta 52 28

allocation of resources. The new Member States Hungary 52 30 are benefiting from the EU's solidarity principles Poland 48 34

which imply significant transfers of EU funds, Cyprus 47 33 Cz e ch Re p. 46 33

while the incumbents have access to a large Estonia 41 36 internal market and a large potential supply of Slovakia 41 37

labour. In addition, the obligation to adopt the Latvia 41 37 Lithuania 40 37

common currency requires vigorous efforts to Bulgaria 39 40 achieve nominal convergence in the new Slove nia 38 40

Member States, which so far has fostered Rom ania 35 45

positive economic outcomes, as confirmed by the Turke y

32 49

0 20 40 60 80

countries which have already joined the euro Pe rce ntage "Do not In favour % Against % area and met the relevant criteria (Cyprus, Malta, know" not shown.

Slovakia and Slovenia). Source: Standard Eurobarometer 58

Sentiment about enlargement in general 1.2. EXPECTATIONS REGARDING THE FIFTH fluctuated considerably (Graph II.1.2). Support

ENLARGEMENT for enlargement peaked above 50% in the period between autumn 2001 and autumn 2002.

The results of several studies conducted in the Subsequently, it began to decline as the EU run-up to the 1 May 2004 deadline were broadly economy entered a period of slow growth and the consistent in showing notable benefits from enlargement date approached, until those in

European Commission

Five years of an enlarged EU

favour were slightly outnumbered by those EU population, even in the current difficult against in spring 2004. Nonetheless, strictly context of economic slowdown and global

related to the accession of the ten new Member financial distress. States in May 2004, the public opinion was still favourable. The surveys conducted after the accession of the ten new Member States reflect a 1.3. EU ECONOMIC GOVERNANCE state of mind more favourable to enlargement from those countries, so that once again more The EU's governance system is designed to allow than 50% of the EU citizens were taking a the pursuit of key economic policy objectives set positive view of enlargement in the autumn of out in the Maastricht Treaty, aiming at sustained 2004. But again, support for enlargement non-inflationary economic growth, a high level continued to fall after accession and hit a fairly of employment and the smooth functioning of low 44% in the autumn of 2008. the EMU. The system is based on the 'four freedoms' relating to the movement of goods, Graph II.1.2: Opinions on enlargement services, capital and labour in the European 60 (EU-15 pri or to May 2004, EU-25 and 27 afte rwards) Union, and it comprises two main pillars – the

% Lisbon strategy and Economic and Monetary

50 Union.

for

40 The Copenhagen economic criteria are derived against from the main characteristics of the EU's system

30 of economic governance. Given the socialist legacy of many of the economies of the

20 candidate countries, the European Council don't know regarded the approximation of their economic

10 systems to those of the Member States as a prerequisite for a smooth integration into the EU

0 Single Market and a sustainable catching-up in 2000 2001 2002 2003 2004 2005 2006 2007 2008 living standards. Therefore, from an economic

Source: Eurobarometer, Issues 54 to 68 viewpoint, entry into the European Union signified (i) a fully functioning open market

Overall, the initial expectations around the economy capable of withstanding free benefits of enlargement to the East were positive, competition, (ii) the adoption of the economic among both experts and the public, and legislation included in the 'acquis especially in the new Member States. As the communautaire', most notably the rules of the remainder of the study will show, this optimism Single Market and (iii) a commitment to the proved to be well founded. Moreover, a survey future adoption of the euro. At the same time, the carried out in 2008 reveals that close to half of political Copenhagen criteria require candidate the EU citizens (48%) consider that enlargement countries to achieve stability of institutions from 15 to 27 countries has strengthened the guaranteeing democracy, the rule of law, human European Union and just over a third of rights and respect for, and protection of,

Europeans (36%) think that enlargement has minorities.

weakened it. Again, enlargement is viewed very

favourably in the new Member States, whereas in The Lisbon Strategy, one of the two main pillars the old Member States, views are more divided of the EU's system of economic governance, (44% "strengthened" vs. 40% "weakened"). relates to specific objectives of economic reform. However, the various benefits associated with It concentrates on creating growth and jobs and the fifth wave of enlargement came at a cost in brings together at national level and at terms of adjustment, which gradually translated Community level all the necessary reforms in into the current 'enlargement fatigue'. employment and in macro- and micro-economic Nonetheless, the enlargement policy continues to policies. This Strategy is based on the proper be supported by a relatively large share of the functioning of the Single Market and of labour

Chapter II

Five years in the EU: achievements and experiences

markets, as well as on the strengthening of political criteria, such as the rule of law. For competition. Romania and Bulgaria, a special Cooperation

and Verification Mechanism was set up to assist The second main pillar of the economic them even after accession to complete judiciary governance system is the Economic and reforms and strengthen the fight against Monetary Union. A single monetary policy is corruption and organised crime (Box II.1.2). entrusted to the Eurosystem, comprising an independent, supranational European Central

Bank (ECB) and the national central banks of the 1.4. CHALLENGES AND OPPORTUNITIES FOR euro area, while the responsibility for other THE NEW AND OLD MEMBER STATES economic policies remains decentralised in the AND THE EU AS A WHOLE hands of national (or sub-national) authorities, but subject to common rules. The Eurosystem In terms of joining the European Union, the formulates a single monetary policy in the light principal challenge for the new Member States of developments in the euro area as a whole, initially was to achieve the transition to a market pursuing its primary objective of maintaining economy or to make sufficient progress in that price stability. On the other hand, responsibility direction, and to comply with the Copenhagen for fiscal policies, labour market and economic criteria. To that end, economic policies employment policies and many microeconomic focused on achieving a high degree of and structural policies remains largely with the macroeconomic stability, closely followed by a national or sub-national authorities. This builds vigorous implementation of structural reforms to on a strong tradition of "subsidiarity", which foster an economic environment favourable to gives the responsibility for policy to the Member private sector activities. For the most part it was States wherever possible. This nonetheless the old Member States that were faced with the requires a certain degree of coordination in order challenge of adjusting the structure of their to take advantage of spill-over effects. economies following the integration of low wage Consequently, a coordination framework – the economies in the Single Market. Viewed in Stability and Growth Pact – has been set up to broader terms, this adjustment which was foster the pursuit of common objectives against triggered by globalisation represents both a the background of economic integration and challenge and an opportunity for all the EU interdependence. economies. Indeed, in preparing for the 2004

enlargement, the EU experienced at first hand the The new Member States have joined the EU as challenges and possibilities that globalisation "Member States with derogation" (i.e. they have would ultimately bring for open economies. no opt-out clauses regarding the adoption of the euro). This means that they did not adopt the ew Member States euro immediately upon accession, but will do so when they meet the necessary conditions. Indeed, In retrospect, the reform agenda of the recently all of the new Member States are committed to acceded Member States appears to have been adopting the euro and their policies are geared defined by four priorities: (i) macroeconomic towards achieving the necessary degree of stabilisation, (ii) privatisation and restructuring convergence with the euro area. of enterprises, (iii) improving the business

environment, and (iv) upgrading the performance The transposition of the acquis represents a of labour markets. These priorities all support the critical challenge for the recently acceded overarching objective of raising productivity Member States and it is directly linked to their growth and accelerating real convergence in participation in key policy areas of the EU, such order to raise living standards and improve as agriculture, environment, transport and economic and social cohesion and welfare in a energy, social matters, the judiciary and sustainable manner. employment. Transitional periods of up to 12 years were allowed in certain critical areas. First, all acceding countries had achieved a Moreover, some new Member States had to sufficient degree of macroeconomic stability by make particular efforts in order to comply with the time of accession, regardless of their

European Commission

Five years of an enlarged EU

Box II.1.2: Cooperation and Verification Mechanism with Bulgaria and Romania

When Bulgaria and Romania entered the EU on 1 The Commission has adopted first reports on January 2007, shortcomings remained in judicial progress in both countries in June 2007 and an reform, the fight against corruption and for updated report in February 2008. A third set of Bulgaria also in the fight against organised crime. reports was adopted by the Commission on 23 These shortcomings entailed the risk that both July 2008. On the same day, the Commission also countries would not be able to correctly apply adopted a special report on the management of community law and that the people of Bulgarians EU funds in Bulgaria. The Council takes a close and Romania would not be able to fully enjoy interest in the Cooperation and Verification their rights as EU citizens. In order to assist Mechanism and has adopted Council Conclusions Bulgaria and Romania to remedy these each time the Commission has issued a report. shortcomings and, at the same time, monitor the The last conclusions adopted on 15 September progress made, a Cooperation and Verification 2008 acknowledge the efforts of both countries Mechanism was set up. and encourage Bulgaria and Romania at the same time to intensify their efforts by demonstrating Since then, the Commission established a close tangible and lasting results. dialogue with both countries and organises regular missions together with independent Further information on the Cooperation and experts during which it meets all relevant Verification Mechanism can be found at the governmental and non-governmental institutions. following website: Both countries have adopted an action plan and http://ec.europa.eu/dgs/secretariat_general/cvm/in report regularly on progress. dex_en.htm

exchange rate arrangements or macroeconomic in a “stop-go” manner, did not push ahead with performance in the initial stages of transition. the economic catching-up process until after Inflation rates have come down to single digits in 2000. Slovenia was a somewhat special case all EU-12 economies and public finances have because of its gradualist approach to reforms and

been largely consolidated. On the other hand, the its weak reliance on FDI inflows. process of rapid credit growth combined with large capital inflows has resulted in large Third, while the business environment in the new external imbalances, particularly in the Baltic Member States gradually improved throughout countries and Bulgaria (also as a result of their the period leading up to and following accession, pegged exchange rates). Securing an orderly it is still not as favourable as in the old Member unwinding of external imbalances remains a States (World Bank, 2009). In 2005, the World challenge to macroeconomic stability and Bank study reports that the gap between the growth, particularly given the current financial average ranking of incumbent and new Member market turmoil. States was 15 points; in 2008 this had improved to only 13 points. Most of the recently acceded Second, the privatisation, restructuring or Member States are currently seen as destinations liquidation of non-viable, state-owned where business can be conducted easily and, as enterprises was an economically and politically such, they even rank higher than some of the difficult task, and the candidate countries taking incumbent Member States. Nonetheless, part in the fifth enlargement accomplished it at challenges in terms of making further different speeds. The economies which advanced improvements in the business environment more rapidly in transition, such as Hungary, remain, in particular in areas such as issuing Poland, Czech Republic, Slovakia and the Baltic licences, employing workers, paying taxes and countries, were able to attract a critical mass of closing a business. FDI and reach higher growth rates at an earlier stage. Other countries, such as Romania and Finally, the most pressing challenge still seems Bulgaria, where reforms had been implemented to be how to improve labour market

Chapter II

Five years in the EU: achievements and experiences

performance, particularly in the context of the These concerns were by no means unique; in ageing process. The labour participation and fact, they constitute a family of issues that have employment rates are still lower than in the emerged through Europe's encounter with the incumbent Member States and the persistently broader process of globalisation. In reality, the high levels of unemployment and the adjustment challenge posed by the fifth concentration of unemployment among certain enlargement is not so very different from the groups and regions suggest that structural structural changes that are called for in the rigidities are continuing to hamper the smooth vigorously unfolding process of globalisation. functioning of the labour markets in the new Indeed, many EU-15 industries and companies Member States. There are still gaps between the took advantage of the favourable cost levels of education and training in the old and the differentials of the new Member States, good new Member States, as witnessed inter alia by location opportunities and cultural ties by the results of the Programme for International splitting their production chains and engaging in Student Assessment (OECD, 2007). This has vertical specialisation. This allowed them to adverse effects on the availability of skilled enhance their world-wide competitiveness and labour in the new Member States. Critically, conquer new markets globally. The examples of despite having achieved substantial gains in the automotive industry, which expanded in labour productivity in recent years (which Poland, the Czech Republic, Slovakia, Hungary reflects some shedding of labour), productivity and Romania, and the ICT industries moving into levels in the new Member States continue to be Hungary and the Czech Republic, are quite substantially lower than those in the incumbent instructive in this regard.

Member States, as is illustrated by the income differential. It is therefore clear that the main economic

benefits of the fifth enlargement are not Old Member States primarily the result of the slightly higher overall

economic weight of the EU-27 in the world The old Member States have also been economy, but the result of the synergies and confronted with various challenges during and economic dynamism that this association of after the fifth enlargement. Serious concerns Member States has made possible. In addition, have been widely expressed about job security the rapid economic transformation of the new and the impact of enlargement on incomes. A Member States, for example, in the area of survey from 2002 (Eurobarometer 56.3) revealed energy liberalisation, direct tax competition or that only 29% of the EU-15 citizens believed that labour market reforms, has also put pressure on enlargement would help create jobs in their the EU-15 countries to bring forward more country. At the same time, a large percentage vigorously the reforms that are necessary to (48%) of those Europeans surveyed considered modernise their social security systems, improve that enlargement would trigger a major wave of the business environment and raise the quality of migration from Central and Eastern Europe. public finances – all of which form part of the Around 70% of respondents were worried about Lisbon strategy. As a result, significant dynamic such a development, fearing an increase in economic benefits have accrued to both the new unemployment and crime, and a lowering of and the incumbent Member States, which are living standards. Another survey on enlargement associated with reforms and greater carried out in 2006 (Special Eurobarometer 255) specialization across a market of 500 million highlighted broadly similar concerns related to consumers. employment, relocation to countries with cheaper labour, and immigration. These views provided a stark illustration of the need to adjust to 1.5. THE ENLARGED EU IN THE GLOBAL competition from the lower wages, skilled labour ECONOMY force and strengthening market economies in the new Member States. While the new Member States accounted for

about 21% of the EU population, they The EU as a whole contributed only about 7% of GDP. In 2007 their

per capita income reached EUR 8,330, as

European Commission

Five years of an enlarged EU

compared to the EU average of EUR 24,810 economic weight of the recently acceded (Table II.1.1). This represents about one third of Member States was larger than their share in the the EU average, whereas it had been one quarter world's population, bringing the enlarged EU up three years earlier. With economic growth to a level of 30.8 percent in 2007. Measured in significantly stronger in the recently acceded PPS terms, the contribution of the new Member Member States, the initial income gap between States is more substantial (Table II.1.1). them and the EU average is narrowing. Equality of income distribution - at 0.3 - is better achieved The EU is an open economy and the fact that in the EU, with Japan being the only nontwelve more countries now fall under a single set European country that has a lower Gini of trade rules, a single tariff, and a single set of coefficient (Table II.1.1). The Gini coefficient is administrative procedures across an enlarged EU used to measure income inequality within a has facilitated trading for the EU's partner population, and ranges from zero (total equality) countries. On aggregate, the EU is the world's to one (where all the income accrues to one largest trader. In 2007, EU imports amounted to person) (World Bank 2008, World Development 18.0% of world total imports and EU exports to Indicators). 16.8% of world total exports (Table II.1.1). The recently acceded Member States contributed 1.6 Graph II.1.3: The EU after enlargement in perspective and 1.2 percentage points to the EU's shares of

8 Population 22 % of world total (excluding intra-EU world imports and exports respectively.

% of world total EU-27 EU-25 21

flows, average of export, import) Although the new Member States’ share of world

7 20 Trade

US trade is rising significantly over time and trade

EU-15 19 6 18 EU-25

EU-15 EU-27 figures are higher compared to the period before

17

5 US 16 the latest enlargement in 2007, the EU share of

15 world exports fell from 18 percent in 2004 to

4 14

99 00 01 02 03 04 05 06 07 08 99 00 01 02 03 04 05 06 07 08 16.8 percent in 2007, as very dynamic emerging

32 % of world total GDP 7 % of world total Surface EU-27

EU-25 economies such as China and India have gained

6 US 30

US

5 importance on the world market.

28 4

EU-27 EU-25

26 3 EU-15 It should be noted that these figures do not

EU-15 2

24

1 include intra-EU imports and exports, the

22 0 volumes of which are roughly twice that of extra

99 00 01 02 03 04 05 06 07 08 99 00 01 02 03 04 05 06 07 08 EU imports and exports. If these flows were to

Source: Commission services (AMECO), IMF be taken into account, after the 2004 enlargement the EU share of world imports and exports would

The accession of these new Member States has be more than 40%. With enlargement, trade is added 1.6 percent of the world's population to the rising particularly within and with the new EU, bringing its share of the world population in Member States. While intra EU-15 exports 2007 to about 7.5 percent (Graph II1.1.3). When increased by 20.7% between 2004 and 2007, land surface is also taken into account, the EU is intra EU-10 exports increased by 180.7% and a relatively densely populated area of the world. exports between EU-15 and EU-10 increased on However, demographic trends are less favourable average by 84.2%.

and point to a 20 percent decline in the

population of the recently acceded Member Confronted with the emergence of new States by 2050 (against an increase of 2% in competitors on the world market, the EU has incumbent Member States). On aggregate, the performed fairly well compared to the United EU’s share of world population is projected to States or Japan, based on the results of a recent fall to 5.2 percent by 2050 from 7.5 percent in comprehensive market share analysis (Cheptea, 2007. Demographic trends are more favourable Fontagné and Zignago, 2008). This is partly due for the US and other high income countries, and to an upgrading of its products and to a more even more so for emerging economies, and this pronounced deepening of the division of labour has implications for the economic growth within its integrated economic space. As the potential. With 2.1 percent of world GDP, the development of intra-EU trade indicates, a rapid

reorganisation of the specialisation is taking

Chapter II

Five years in the EU: achievements and experiences

Table II.1.1: The enlarged EU in the global economy, 2007

EU-27 NMS US Japan China India world

Population, million 494 103 302 127 1 320 1 123 6 612

      average % change, 2000-2007 0.4 -0.3 1.0 0.1 0.6 1.4 1.2

     % of world total, 2007 7.5 1.6 4.6 1.9 20.0 17.0 100

     million, 2050 479 82 402 103 1 409 1 658 9 191

     % of world total, 2050 5.2 0.9 4.4 1.1 15.3 18.0 100

GDP current, billion EUR 12 243.1 852.8 10 093.5 3 198.6 2 397.1 855.8 39 717.9

     % of world, current 30.8 2.1 25.4 8.1 6.0 2.2 100

     % of world, PPS 22.2 2.6 21.1 6.5 10.8 4.7 100

GDP/capita in EUR 24 810 8 330 33 464 25 034 1 816 762 6 007

     in PPS, average % change 2000-2007 2.5 6.2 1.5 2.1 11.2 7.7 2.6

real GDP, average % change 2000-2007 2.1 4.7 2.4 1.5 10.2 7.6 3.1

Gini coefficient 0.3 0.3 0.4 0.3 0.5 0.4 :

Share of world imports (excluding intra-EU) 18.0 1.6 18.6 5.6 8.8 2.2 100

     Share of world exports (excluding intra-EU) 16.8 1.2 11.5 7.0 12.0 1.5 100

FDI inflows, % of world total 46.4 4.5 13.4 : 5.8 : 100

     excluding intra-EU 19.0 : 20.0 : 9.0 : 100

Stock market capitalisation (% of GDP) 86.8 : 132.6 92.0 : : :

     Stock trade (% of GDP) 160.8 17.1 308.5 148.4 237.5 94.6 181.8

Source: World Bank (World Development Indicators), Commission services (AMECO), Eurostat

place among old and new Member States and example, would be 20 percent and 9 percent such shifts are likely to strengthen the EU’s respectively. competitiveness in world markets. However, at Member State level, the performance is mixed. Some Member States (e.g. the UK and the 1.6. AN ENHANCED INTERNATIONAL ROLE Netherlands) are switching from industry to services, while other Member States (e.g. Due to its increased weight, the European Union Germany) remain highly specialised in has assumed greater prominence in international manufactured goods, recording resilient market fora, as well as in international trade shares at world level. Other Member States (e.g. negotiations, since the accession of the new France) have failed to adopt proactive Member States. At the same time, the competitiveness policies at the micro level and strengthening of the EU's international presence have lost market share for manufactured products has compounded some of the problems that without making a clear transition over to already existed in terms of coordinating Member services. The best performing Member States are States' positions and the benefit of speaking with those which have developed the most a single voice in certain international institutions. overlapping production chains, and these often include partners from the new Member States. With regard to the external representation of the

EU - and, in particular, of the euro area - in the Net inflows of foreign direct investment give an Bretton-Woods Institutions, several observers indication of an economy's competitiveness. In (Bini-Smaghi, 2004, 2006a and 2006b; Sapir, the EU, FDI inflows in 2007 reached 46.4 2007; European Commission, 2008) have percent of global investments, of which the new emphasized that the representation could be Member States accounted for 4.5 percent (Table strengthened if some consolidation were to take II.1.1). This compares relatively well with other place. The current state of fragmentation means major economies. FDI inflows to the US reached that the EU punches below its global economic 13.4 percent and to China 5.8 percent. If the EU weight in multilateral fora. This is the main were considered as a single economy and intrareason why, despite their large aggregate voting EU flows were excluded, the EU’s share of share and large number of seats in the IMF the global FDI net inflows would shrink to about 19 EU countries are perceived as being less percent while those for the US and China, for influential than the United States, which has only

European Commission

Five years of an enlarged EU

about half the aggregate quota of the EU. In this countries and, albeit to a much lesser extent, in context, the increasing economic weight of the terms of internal consensus building. emerging market countries feeds a growing perception that Europe is over-represented, in An EU of 27 Member States has become an even terms of both seats and aggregate voting power more interesting entity for third countries to enter (Boyer and Truman, 2005; Truman, 2006; into Free Trade Agreements (FTA) with. Trade Adams, 2006; Bergsten, 2006), which in turn negotiations have recently been initiated with - increases the pressure for reforming the Bretton amongst others - the ASEAN countries, India, Woods Institutions. South Korea and Ukraine, whilst a number of other countries have also signalled their interest The situation of the EU's representation in the to start such negotiations. OECD and the "G groups" (G-7 and G-8) is somewhat different. Since the foundation of the Enlargement has led to a wider diversity of OECD, the European Community has enjoyed a interests of Member States in industry, special status in that institution. Under the agriculture and services, thereby making it even institutional arrangements of the EC Treaty, in more important for the Commission to areas of exclusive Community competence, the adequately address the offensive and defensive Commission represents the Community's interests of all Member States in both

position and Member States are expected to multilateral and bilateral negotiations ( 2 ).

follow it. The main challenge here is to ensure Traditionally, there is a broad consensus amongst representation of all EU Member States in the Member States as to the overall principles and OECD and - pending the achievement of that priorities of EU trade policy, the main fault line situation - to facilitate their representation via being between those who are prepared to make coordinated positions by the European far-reaching concessions in the agricultural Community. Some progress has been made, as sector in order to obtain concessions from others the Czech Republic, Hungary, Poland and in the negotiations, and those who are less Slovakia were accepted as members of the prepared to do so. The new Member States tend organisation. Furthermore, in May 2007, the to reinforce the latter position, which obliges the OECD opened accession discussions with Commission and the Presidency to put more Slovenia and Estonia among other countries. A resources into consensus-building, although this similar situation applies in the case of the G-7 does not dramatically change the way in which

and G-8 groups, where only four Member States the various interests are balanced out. are represented and the representation of the European Union is relatively limited. As the new The increased influence of the EU in the world Member States do not currently have any economy and diplomacy extends far beyond prospect of individual accession to these groups, what is shown by the statistics. The EU is the best option for their representation appears to becoming an economic and political centre of be through a cohesive and coordinated voice on gravity in the emerging international order. The the part of the European Union. EU's large internal market provides attractive and profitable opportunities for outsiders who wish to The increased economic weight of the EU has access it, yet the rules of access and trade within strengthened its position as the world's main the EU are determined by the EU itself. It is trading power. The new Member States have inevitable that the EU's rules and regulations brought in new expertise in a number of applying to the internal market will ultimately geographical areas (for example in Eastern become more widely accepted by those who Europe, the Black Sea Region, the Caucasus and wish to access it, in the sense that they become the Western Balkans) and sectors (for instance international benchmarks which other nations energy transit). The enlarged Single Market has further enhanced the EU's attractiveness and influence in multilateral and bilateral trade

negotiations vis-à-vis its partner countries. On (

2 ) However, enlargement has not affected internal

the other hand, enlargement has created new consensus building in the anti-dumping and anti-subsidy committees in which the differing interests of the new

challenges in terms of deal-making with third Member States have balanced out.

Chapter II

Five years in the EU: achievements and experiences

must adopt. The enlargement to 27 Member

States has effectively enhanced the importance of the EU in this regard. Together with the increasing membership of the euro area, the international role of the EU has grown to an unprecedented degree in recent years.

• 2. 

  ECONOMIC PERFORMANCE IN AN ENLARGED EU

In this section we will analyse the economic followed different methodologies and performance of the enlarged EU in an effort to approaches, their results are broadly consistent show that, in line with the ex-ante estimates, with each other and point to the prospect of growth in the new Member States increased notable gains from enlargement. Enlargement significantly following their accession to the EU. was expected to be beneficial for all Member The economic expansion, which was partially States, but especially so for the acceding based on an improvement of the capital stock and Member States, partly because of their smaller an increase in productivity, allowed a narrowing economic size relative to the old Member States, of the income gap between new and old Member where the enlargement shock would be States. The old Member States benefited from proportionately more pronounced, and also accession, too, in particular those which because of their lower level of development that increased their foreign direct investment and would lead to a convergence process. Intensified trade with the new Member States. commercial links, strong foreign direct

investment flows, lower risk premiums, greater However, part of the acceleration in growth in a efficiency as a result of adopting market number of new Member States seems also to mechanisms, macroeconomic stability and have been driven by excessive demand, which structural reforms stimulated by membership of resulted in a positive output gap and mostly the EU were considered to be some of the main benefited the financial and construction sector. factors behind these good results.

Moreover, there was a shift in the composition of investment from machinery to housing, a trend A study by the European Commission's which was also observed in some of the old Directorate-General for Economic and Financial Member States. In 2008, this eventually led to a Affairs (European Commission, 2001) projected sharp growth correction. Whether or not this additional growth of 1.3/2.1% per year for the setback in the catching-up process is a temporary new Member States in 1994-2009, while in the one will crucially depend on the orderly old Member States’ growth was put at a unwinding of the macroeconomic balances that cumulative 0.5/0.7% higher. Similar orders of have been built up and on the resumption of magnitude are provided by both Baldwin et al. growth brought about by productivity-enhancing (1997), who estimated that real income would investment and a highly-skilled labour input. stay 0.2% higher in the old Member States and

between 1.5% and 18.8% in the new Member The first part of this section presents the ex-ante States, and Breuss (2002) who assessed the estimates of the economic impact of average GDP impact at 0.5% for the bulk of the enlargement. The section goes on to look at the old Member States and at between 5 and 9% for changes in income differentials between and the Czech Republic, Hungary and Poland in within the EU Member States in the pre- and 2005-2010. Heijdra, Keuschnigg and Kohler post-enlargement period. It also considers the (2004) predicted the overall steady-state welfare evolution of GDP growth and its composition in impact for the old Member States at 0.3% of terms of demand, sectoral make-up and GDP. On the other hand, Maliszewska (2004) production. In conclusion, it analyses the finds a somewhat lower impact on the GDP relationship between economic integration and equivalent of long-run welfare, a negligible macroeconomic stability. impact on the old Member States, and gains of

7% for Hungary and 3.4% for Poland. Moreover - and this is an important factor - the new

2.1. EX-ANTE ESTIMATES OF THE ECONOMIC Member States would lose 0.1% of GDP if IMPACT OF ENLARGEMENT enlargement did not take place.

With a view to gaining a more concrete idea of The impact on individual old Member States the potential effects of enlargement on the new varies, with countries on the former eastern and the old Member States, several empirical border of the EU expected to benefit most from studies were undertaken in the run-up to May the enhanced opportunities for trade and 2004 deadline (Box II.2.1). Although the studies investment. Germany’s GDP could be 0.5%

Chapter II

Five years in the EU: achievements and experiences

Box II.2.1: Pre-enlargement empirical studies on the potential economic impact of enlargement

Year of Results Author study Method Area covered Variable Impact Period Any other remark R. Baldwin 1997 General EU-15 GDP +0.2 % Steady state DE and AT benefit J. Francois equilibrium more R. Portes model

CEEC7 GDP +1.5/18.8% Steady state Lower risk premium (CZ,HU,PL, is driver for stronger SI,SK,BG, RO) result

EU-15 Public finance EUR -19 bn 1999 Enlargement (-0.2% of GDP) includes CZ, HU,PL,SI,SK

F. Breuss 2002 OEF world 13 of EU-15 GDP +0.5% 2005-2010 For ES, PT, DK the macroecon. HU, PL +8/9% 2001-2010 costs exceed the

model CZ +5/6% 2001-2010 benefits. DG ECFIN 2001 Growth AC-8 GDP growth +1.3%/2.1% 1994-2009 Central/optimistic

accounting scenario. Significant analysis CEEC-10 +1%/1.8% Annual impact in NMS, modest in EU-15. EU-15 +0.5%/0.7% Cumulative

M. Grassini 2001 Multi-sectoral Italy GDP +0.5% 2000-2010 Specialisation

R. Bardazzi model GFCF +0.3% scenario reported.

A. Missale (INTIMO) Imports +0.6% Spill-overs double

Exports +1.2% the impact. B. Heijdra 2002 General EU-15 Overall welfare +0.3% Steady state Trade, budgetary C. Keuschnigg equilibrium in % of GDP costs and migration W. Kohler model effects are

considered. W. Kohler 2004 Individual EU- Overall welfare +2% (AT)/ Steady state Besides PT, also a

15 countries in % of GDP -1.3% (PT) negative impact in EL, IE and ES.

C. Keuschnigg 2002 Calibrated Austria GDP +0.6% Long-run scenario is reported. Fiscal

W. Kohler general Contribution to position improves, despite higher net equilibrium EU budget +1.6% of GDP contributions to EU. Expected wage model Exports +15.9% spread constant. Only immigration of

Consumption +0.7% unskilled may widen the wage spread Wage +0.5%

C. Keuschnigg 2001 Calibrated Germany GDP +0.5% Long-run membership scenario is

M.Keuschnigg dynamic Exports +46.7% reported. Investment led expansion.

W. Kohler general Wage income +0.5% Expanded activity swells the tax equilibrium Skilled and +0.6% base. Some potential for adverse model unskilled wage redistributive effects

T. Kristensen 2001 Structural, Denmark GDP -0.5% 2000-2010 In the long run,

P. Rørmose dynamic, Exports +0.6% positive effects from

Jensen macro Imports -0.6% immigration and econometric productivity

model of the GDP +1.4% 2000-2065 outweigh short-term Danish Investment +1.3% (scenario of costs. economy Employment +1.3% neutralised (ADAM) Wage rate -0.8% budget effect)

A. Lejour 2001 General EU-15 Welfare effects +0.1/0.6 Long-run Single market/

R. de Mooij equilibrium CEEC-7 in % of GDP +5.3/-1.8 labour migration

R. Nahuis model

(WorldScan) M.Maliszewska 2004 General EU-15 Welfare effects +0.03% Long-run Base scenario

equilibrium Hungary of trade +7% model Poland liberalisation in +3.4% % of GDP

Source: Commission services

European Commission

Five years of an enlarged EU

higher in the long run (Keuschnigg et al., 2001) and Bulgaria, where income stood at less than and Austria’s 0.6% higher (Keuschnigg and one quarter of the EU-15 average, but has risen Kohler, 2002) compared to the no-enlargement to more than one third in the last five years. Of scenario. Italy is estimated to gain 0.5% of GDP the twelve newly admitted countries, Cyprus, in 2000-2010 (Grassini, Bardazzi and Missale, Slovenia, the Czech Republic and Malta have the 2001) and, according to Kristensen and Rørmose smallest gap relative to the average of the Jensen (2001), Denmark’s GDP is likely to original members; in fact, the gap is even smaller decrease in the short run (2005-2010) by 0.5%, than that of Portugal, which is more than 30% although it should increase in the long run (2000- below the average of the old Member States. 2065) by 1.4% above the no-enlargement scenario. Kohler (2004) discerns a large negative Between the two reference periods all new steady-state welfare effect in the case of Portugal Member States were able to narrow the gap, (1.3% of GDP) and also in the case of Greece, except for Malta, where the distance remained Spain and Ireland; the other old Member States the same. Among the original EU Members, Italy show gains, with Austria gaining the most (2% was falling behind somewhat, whereas above the no-enlargement scenario). Luxembourg, Ireland and Greece improved their relative position considerably. As regards the possible negative impact of labour migration on wages and the standard of living of Graph II.2.1: Per capita GDP in the EU some vulnerable segments of the labour market

in the old Member States, aggregate data 140

LU (206, 241)

2008 IE

produced no conclusive evidence. In fact, the 120 NL wages of both skilled and unskilled labour are UK SE AT

likely to increase in the long run by 0.5% in O MS ave rage = 100 DK FI BE 100

Germany (Keuschnigg et al., 2001) and 0.6% in ES DE GR FR

Austria (Keuschnigg and Kohler, 2002). In 80 SI C Y IT C Z

Denmark, however, Kristensen and Rørmose EE SK MT

Jensen (2001) believe wages would be lower in 60 LT

the long run (2000-2065). Lejour, de Mooij and NMS

HU PT

LV PL

Nahuis, (2001) estimated that labour migration 40 RO

would have a long-run impact in the old Member BG 1999

States equivalent to 0.6% of GDP, but the 20

outflow of labour would cost the new Member 20 40 60 80 100 120 140

States 1.8% of GDP. Source: Eurostat, Commission services

These results suggest that countries with lower 2.2. CLOSING THE INCOME GAP initial per capita GDP tend to grow faster,

thereby catching up with the other EU countries. This section focuses on income inequalities This inverse relationship between growth and the within the EU and analyses whether and how level of income is called “beta-convergence”. If quickly the gap between poorer and richer this factor is present, poorer countries are able to countries is narrowing over time, and whether draw nearer to their richer peers. convergence between countries comes at the expense of divergence within the countries. Sala-i-Martin (1996) investigated betaconvergence

across regions in the United States,

2.2.1. Real convergence and initial per Japan and five European nations. It was

capita GDP conjectured that the speed with which a region or

country closes the relative income gap with Average per capita GDP in the recently acceded respect to the others is dependent on the actual countries amounted to 40% of the average of the size of the gap. This speed of convergence was 15 old Member States five years before found to be surprisingly stable across regions and enlargement, reaching 51.7% in 2008 (Graph was estimated at around 2% per year. Thus, the II.2.1). The largest gap was recorded in Romania

Chapter II

Five years in the EU: achievements and experiences

growth rate of a country where per capita GDP is enlargement decreased. However, this increase in some 10 percent below the average of the income equality was due to diminishing reference group of countries should be roughly disparities among the new Member States, as 0.2 percentage points higher than the average there was no further convergence among the old annual growth of that reference group. EU Member States.

Table II.2.1: Estimation results for beta-convergence in EU-27 To sum up, the new Member States with low per

Estimated equation: capita GDP are not only catching up with their ∆ln(GDP per capita) = α - β·ln(GDP per capita(-1)) wealthier peers in relative terms, but they are Period α β doing so at a fast enough pace for absolute

1999-2003 0.277 0.023

t-value (6.43) (5.24) income inequalities to diminish over time.

2004-2008 0.397 0.034

t-value (9.07) (7.77) Graph II.2.2: Sigma-convergence in the EU

Note: Pooled Least Squares with period fixed effects 55 C oe ffi ci e nt of variati on

Source: Commission services

50

45

The relationship between growth and the level of O MS* NMS 40 per capita GDP was estimated for the 27 EU EU-27 EU-26* 35

countries for the five years before and after 30

enlargement (Table II.2.1). Results show that

beta-convergence took place, supporting the 25

notion that countries with a lower income level 20

(the new Member States) were growing at a 15 faster pace. Furthermore, while the speed of 10 convergence in the pre-accession period was 5

2.3%, roughly matching the result of Sala-i 0

Martin (1996), it increased further to 3.4% 99 00 01 02 03 04 05 06 07 08

following enlargement. The acceleration of the Note: * Excluding Luxembourg

catching-up process in the post-accession period Source: Eurostat, Commission services

was also indentified by Rapacki and Próchniak

(2009). 2.2.2. Cross-country convergence and within-country divergence

It is also of interest to know whether absolute

inequalities among countries are being reduced According to the Williamson-curve hypothesis over time. Although beta-convergence (which (Williamson, 1965), the relationship between a ensures that Member States with lower per capita country's economic development and within GDP grow faster than higher-income countries) country regional disparities follows a reverseis necessary in order for absolute income inverted U-shaped curve (Graph II.2.3). The differences to disappear, it may not be sufficient. hypothesis is based on the argument that, in the Indeed, if the income difference is wide and the early stages of development, capital and skilled poorer country is growing only moderately faster labour tend to concentrate in a few regions which than the richer one, the absolute income drive the country's economic growth. difference may actually increase. The notion that Subsequently, agglomeration diseconomies (such absolute per capita GDP disparities are being as higher factor costs), knowledge spillovers and reduced over time is known as 'sigmafiscal transfers can cause a more balanced convergence'. distribution of productive factors across regions.

With regard to sigma-convergence in the Following Szörfi (2007), the weighted standard enlarged EU (Graph II.2.2), it was found that deviations of regional (NUTS level 2) GDP per income dispersion remained largely the same capita levels divided by the countries' GDP per during the 10 years examined. However, if capita level are used here as an index to measure Luxembourg was excluded, the dispersion after regional disparities within countries.

European Commission

Five years of an enlarged EU

Graph II.2.3: Regional disparities and per capita GDP in 1995- the majority of the old Member States rely on a

2005 more regionally-balanced growth. Furthermore, a

0.7 growing number of old Member States have IRD SK managed to initiate increasing regional

0.6 convergence in recent years.

The the ore ti cal Wi l l iamson curve

0.5

0.4 RO C Z BE 2.3. THE QUALITY OF THE CATCHING-UP

NMS

0.3 UK

HU IT A significant catching-up was observed in the FR DE

BG PL PT GR O MS IE AT new Member States and this section explores in

0.2

SI ES

FI more depth the extent to which the catching-up

SE NL

0.1 process in the enlarged EU has relied on

Pe r capi ta GDP i n PPS as % of the EU27-ave rage sustainable dynamics. To that end, the trend in

0.0 GDP growth is analysed from the demand side,

20 40 60 80 100 120 140 in terms of its sectoral composition and of the

Note: IRD = [(SUM((GDPpc_r - GDPpc)^2)/N)^1/2]/GDPpc production factors which were important. The

where IRD denotes the regional disparities index, N is the number of

regions in the country, GDPpc stands for the GDP per capita in the pre- and post-enlargement periods are compared country while GDPpc_r indicates GDP per capita in the region r. and the old Member States are used as a

OMS: EU-15 excluding DK, LU

NMS: SK, RO, CZ, HU, BG, PL, SI benchmark. Capital deepening and increasing Source: Eurostat, Commission services productivity were important drivers of growth, as well as investment in the industrial sector. According to this index, regional disparities grew However, it also appears that part of the in all new Member States for which data are catching-up process relied on exuberant demand, available in the period 1995-2005 and they were financed by cheap credit, which outpaced the higher on average than in the old Member States, supply potential of the economy. This eventually where regional disparities remained broadly led to a sharp reversal in the real convergence stable in most cases. Slovakia experienced the prospects in those Member States with the

highest and also the fastest-growing regional largest macroeconomic imbalances( 4 ).

divergence, while the Czech Republic and

Romania also recorded relatively high and 2.3.1. Growth from the demand side

growing disparities. On the other hand, regional

divergence in Slovenia and Poland ( 3 ) remained GDP growth in the enlarged EU was about 0.1 of

below the average for the old Member States in a percentage point higher on average in the the years 1995-2005. period 2004-2008 than in 1999-2003. While average growth stayed at 2.2% in the old Between 1995 and 2005 Belgium and the UK Member States, it increased significantly in the among the old Member States suffered from the new Member States – from 3.4% in 1999-2003 highest regional disparities, whereas Sweden and to 5.6% in 2004-2008 (Table ). This increase was the Netherlands enjoyed the lowest. Moreover, due to higher domestic demand, which was while the UK and Greece went through partially offset by the negative contribution of substantial regional divergence, Italy and Austria net exports to growth. In the old Member States, recorded some regional convergence. Spain, on the other hand, the growth composition

Ireland and Finland experienced an inverted U- remained broadly stable. shaped curve pattern of regional divergence. After enlargement, the higher growth in domestic Hence, economic catching-up in all new Member demand in the new Member States was driven by States seems still to be predominantly driven by private consumption and gross fixed capital a limited number of regional growth poles, while

( 4 ) For analysis of growth strategies pursued by the new ( 3 ) NUTS level 3 data indicate a substantially higher level of Member States and their comparison with East Asia see

regional disparities for Poland. also Fabrizio, S. , D. Leigh and A. Mody (2009).

Chapter II

Five years in the EU: achievements and experiences

formation, with the growth of government period, some central European countries (Czech consumption being somewhat lower. At the same Republic, Hungary and Slovakia) managed to time, the positive contribution of exports to build on a more balanced composition of growth. growth was offset by an even bigger rise in

imports. The emergence of macroeconomic 2.3.2. The sectoral composition of growth

imbalances as a consequence of the increased reliance on domestic demand put a brake on In a properly functioning market economy, the economic expansion. The deteriorating financing most productive economic sectors will conditions, combined with a sentiment reversal, eventually expand and the less profitable ones led to a severe deceleration of growth in 2008 in will contract, in terms of both their output and most new Member States with large imbalances. the inputs used.

Table II.2.2: GDP growth and its main components In the old Member States, growth was largely

Average annual percentage NMS OMS driven by the financial services sector. This

change in constant prices 99-03 04-08 99-03 04-08 sector has gained in importance, and its post

GDP 3.4 5.6 2.2 2.2

Private consumption 4.0 5.5 2.5 1.7 enlargement contribution to gross value added

Public consumption 3.1 2.3 2.2 1.8 (GVA) growth increased from 0.8% to 0.9%

Gross fixed capital formation 2.0 10.2 2.3 3.4

Exports 8.7 11.8 4.8 5.7 (Table II.2.3). In a group of countries the

Imports 7.9 12.4 5.0 5.6 improvement in performance was led by the Contribution to GDP growth: industry sector (excluding construction). In

 - domestic demand 3.4 6.4 2.2 2.1

 - net exports 0.0 -0.8 0.0 0.1 Germany, for instance, the industrial value added Source: Eurostat, Commission services increased by 1.4% annually prior to enlargement

and by 4.1% after the new Member States joined

The old Member States also enjoyed an in 2004.

acceleration of gross fixed capital formation,

whose positive impact on GDP growth was Table II.2.3: Sectoral contributions to growth offset by a slowdown in private and government NMS OMS 99-03 04-08 99-03 04-08 consumption. Following enlargement, growth in GVA (real annual percentage change) 3.4 5.5 2.2 2.4 Agriculture 0.1 0.0 0.0 0.0

the old Member States was further supported by Industry (excl. construction) 1.0 2.0 0.3 0.5

exports, which outpaced imports. Construction -0.1 0.5 0.1 0.1 Market services (excl. financial) 1.1 1.7 0.6 0.5

Financial services 0.7 1.0 0.8 0.9

Among the new Member States, average GDP Public services 0.5 0.3 0.4 0.3 growth in the five years before enlargement was Source: Eurostat, Commission services

highest in the three Baltic States. After

enlargement, Slovakia replaced Estonia among In the new Member States the acceleration in the three fastest growing economies. While the these sectors was more dramatic. The industrial contribution of domestic demand to growth sector's contribution to growth, which amounted exceeded 6% in only three new Member States to only 1% before enlargement, rose to 2% after (Bulgaria, Latvia and Estonia) during the preenlargement. Similarly, private sector services accession period, four more countries (Lithuania, added only 1.8% to GVA growth in the pre Romania, Slovakia and Poland) joined this group accession period, whereas since 2004 their in the post-accession period. Apart from contribution has been at an average of 2.8%.

Slovakia, the group of the new Member States

enjoying a positive growth contribution from net The large increase in value added in the exports consisted of only Poland, Cyprus and industrial and the market services sectors in the Slovenia in the period before enlargement, with recently acceded Member States is a prominent the Czech Republic and Hungary being included sign of the continuing shift among sectors which after enlargement. is a characteristic of the catching-up process.

Already before enlargement the industrial sector

Hence, while the three Baltic countries plus in the new Member States was beginning to gain

Romania and Bulgaria relied mostly on growth in importance, as newer, more productive driven by domestic demand in the post-accession technologies were being transferred from the old

European Commission

Five years of an enlarged EU

EU countries. At the same time, resources were production function by analysing the evolution of

also being relocated to the markedly factor inputs, i.e. labour and capital.

underdeveloped services sector. As a result of the

associated rapid expansion of credit to The production function approach makes use of a

households, the construction sector made a simplified production scheme whereby output is

bigger contribution to growth, although - given generated by using a given level of technology to

the deteriorating financing conditions - this is combine with two inputs: labour and capital. In

unlikely to be sustained in the coming years. this approach, output is increased by improving

the technology and/or increasing the amount of

Through the sectoral links between some of the one or both inputs. This method can then be used

old and new Member States, the rapid growth to estimate the fraction of GDP growth that was

recorded in the acceding countries had a spilldue to the increase in the labour input or the

over effect, thereby increasing growth in the capital input, or due to rising total factor

original Member States. At least two patterns can productivity (TFP), which is used in the

be identified (Table II.2.4). production function approach to describe

technology in general.

Table II.2.4: Sectoral contribution to growth in selected regions

Nordic States Central European States The major differences between the old and the

in % FI, SE EE, LT, LV AT, DE CZ, HU, new Member States with respect to the factors of

PL, SK

Total output production are in the stock of productive capital

99-03 2.92 5.91 1.48 3.05 and the level of total factor productivity. In the

04-08 3.81 8.90 2.13 5.35 original Member States the estimated capital Agriculture stock is on average larger than their GDP by a

99-03 0.04 0.09 0.00 0.08

04-08 0.09 0.06 0.02 0.15 factor of three, whereas in the recently acceded

Industry (including construction) countries this ratio is closer to two. Both the

99-03 1.33 1.82 0.23 0.81 lower stock of productive capital and the lower 04-08 1.61 2.54 1.03 2.59 TFP lead to higher rates of capital accumulation

Market services (including financial intermediation)

99-03 1.25 3.34 0.98 1.61 and productivity growth.

04-08 1.88 5.31 0.95 2.28

Public services Faster growth of the capital stock and more rapid 99-03 0.30 0.55 0.25 0.49 improvements in productivity support higher

04-08 0.24 0.83 0.11 0.21 GDP growth in the economies that are catching Source: Eurostat, Commission services up. In the past decade, both capital input and

TFP contributed around 2% to growth in the In the Baltics, the rapidly developing housing recently acceded countries, whereas in the sector and the dynamic growth in consumption original Member States each of these factors served to invigorate market services and, in accounted for only about 1% growth (Table particular, financial intermediation. This affected II.2.5). the same sectors in the neighbouring old Member

States (Finland, Sweden). Export growth Table II.2.5: Production factors' contribution to growth provided much of the momentum in the Average annual percentage NMS* OMS catching-up process in Central European change in constant prices 99-03 04-08 99-03 04-08

countries, and the accompanying boom in the GDP 3.4 5.6 2.2 2.3 Capital 2.3 2.3 1.0 1.0

industrial sector had a positive impact on their Labour -0.9 1.1 0.4 0.5

trading partners among the original Member TFP 2.0 2.2 0.8 0.7

States (Germany, Austria). Note: * EU-10 countries Source: Eurostat

2.3.3. Growth seen from the production side At country level, in the new Member States of

The previous sections have looked at demand the Baltic area and in Bulgaria, where the patterns and also investigated the sectoral inherited capital stock was the lowest, the composition of output. This section now contribution of capital to growth amounted to examines the supply side based on the more than 3½% after EU accession. Of the old

Chapter II

Five years in the EU: achievements and experiences

Member States, on the other hand, only 2.3.4. Composition of investment

Luxembourg, Ireland and Spain were able to

achieve rates of more than 2%. In a catching-up context, it is not only the level

of investment that matters but also its

On the other hand, the contribution of labour to composition. Following the EU enlargement of growth varied considerably in the new Member 2004, the GDP share of investment increased in States during the period under review. This was both the old and the new Member States. The due to the transformation of the labour market in rise in investment levels was mainly due to an recently acceded countries. A part of the labour increase in housing construction, while force which was undereducated or whose skills investment in metals and machinery declined. were insufficient to work with the newly Moreover, although the amount of other acquired technologies was often driven out of the construction works increased in the old Member labour market and in many cases became States, it declined in the new Member States. On inactive. Such developments reduced both the the other hand, investment in transport available labour force and the participation rate. equipment stagnated in the original Member The largest drop was recorded in Romania, States, but rose in the Member States that where the participation rate fell by more than 6 acceded more recently.

percentage points between 1999 and 2003.

Table II.2.6: Investment by asset type

Labour market distress during the pre-accession % of GDP AVG EU-27 OMS NMS

years is also confirmed by the trend in the Total 98-03

20.0 19.9 22.9 04-08 20.6 20.4 23.4

average unemployment rate in the recently Metal products and 98-03 5.9 5.8 7.5

acceded Member States which rose from the machinery 04-06 5.2 5.1 6.5 Construction work: 98-03 5.0 5.1 2.8

already high 10.9% in 1999 to 13.8% in 2002 housing 04-06 5.4 5.5 3.0 and then eased somewhat to 12.9% by the time Construction work: other 98-03 5.6 5.4 8.8

of enlargement. However, as the contribution of constructions 04-06 5.8 5.6 8.5

both labour and TFP to growth increased in the Transport equipment

98-03 1.9 1.9 2.3 04-06 2.0 1.9 2.6

post-accession period compared to the pre Source: Eurostat, Commission services accession period, generally speaking there does

not appear to have been a trade-off between Hence, although investment levels increased productivity and employment in the new after the 2004 EU enlargement, the composition Member States. of investment in both the new and the old

Member States has shifted more towards non

The production function method may also be productive housing investment. At the same used to estimate potential growth, i.e. growth that time, while public investment as a share of total would occur if all resources were used to their investment remained unchanged in the old optimal capacity. Combining estimates of the Member States, it increased in the new Member potential contributions of all production factors States. This rise was to a large extent influenced to growth, it is possible to make a rough estimate by the inflows of EU funds, notably cohesion of the difference in potential growth between the funding and higher national co-financing needs.

two groups of countries. If the joint contribution of capital and TFP to growth in the new Member

States remained at least two percentage points 2.4. ECONOMIC INTEGRATION AND higher than in the old Member States, and MACROECONOMIC STABILITY: THE assuming that employment in the recently UNDERLYING CONDITIONS FOR acceded countries could maintain its recent rate GROWTH

of growth without risking an acceleration of

wage inflation, the average potential GDP Growth in the EU as a whole benefited greatly growth in the new Member States could be from economic integration and macroeconomic roughly 2½ percentage points higher than in the stability. First, this section documents the broad original Member States. trends in trade and investment flows in the

enlarged EU and how they impact on business

European Commission

Five years of an enlarged EU

cycle synchronisation. It then goes on to consider States, while enabling foreign investors to better institutional reforms and increased economic allocate their productive resources and thus

linkages among the new and the old Member increase their efficiency and competitiveness. States, and the extent to which these have translated into higher output growth. Lastly, the Graph II.2.4: Inward FDI in the new and old Member States

level of nominal convergence in the enlarged EU 7 % of GDP

and the costs of stabilisation are analysed. The

focus of this section is on the link with growth. A 6 from the re st of the world

more detailed analysis of trade and investment from the O MS 5

flows, cyclical synchronisation and the various aspects of macroeconomic stability is presented 4

later in the report. 3

2.4.1. Integration and business cycle 2

synchronisation 1

Enlargement has had a positive impact on trade 0

in the EU, as the average GDP share of exports 99-03 04-06 99-03 04-06 and imports (openness) increased in both the old O MS NMS

and the new Member States between 1999-2003 Source: Eurostat, Commission services and 2004-2008 (Table ). Moreover, this rise in trade was more pronounced for extra-EU trade According to economic theory, increased trade than for intra-trade flows, with the share of intraand FDI flows can have ambiguous effects on EU in total trade decreasing marginally in the old business cycle synchronisation. While increased Member States, but increasing slightly in the new demand linkages and risk sharing should lead to Member States. Hence, enlargement seems to a higher degree of synchronisation, the related have supported trade creation without leading to potential increase in production specialisation is substantial trade diversion from extra- to intralikely to have the opposite effect. A high degree EU trade. As a result, it has provided increased of business cycle synchronisation facilitates the growth opportunities for producers and a wider implementation of economic policy. choice for costumers.

Graph II.2.5: Output gaps in the enlarged EU

Table II.2.7: Trade patterns in the enlarged EU 1.5

% of pote ntial GDP NMS OMS

99-03 04-08 99-03 04-08 1.0

Opennes 47 56 34 38 Share of intra-EU in total trade (%) 74 76 66 65 0.5 Note: Openness: average GDP share of exports and imports

Source: Commission services 0.0

Apart from facilitating trade flows, EU accession -0.5

was also expected to stimulate FDI inflows O utput gap base d on production function -1.0

through a more attractive business environment

and increased investor confidence. Following -1.5 enlargement, the GDP share of inward FDI -2.0

increased in the new Member States and 99-03 04-08 99-03 04-08 99-03 04-08 decreased in the old Member States, as foreign NMS O MS EU-27 investors from both the old Member States and Source: Commission services the rest of the world appear to have exploited the

improved investment climate in the recently The positive output gap in the enlarged EU acceded Member States (Graph II.2.4). The remained broadly stable at around ½% of GDP increase in FDI inflows is likely to have following the 2004 enlargement (Graph II.2.5). contributed to higher investment, employment This was due to a narrowing of the positive

and productivity growth in the new Member

Chapter II

Five years in the EU: achievements and experiences

output gap in the old Member States, which was 12 new Member States over the same time

almost fully offset by a dramatic reversal of the span( 6 ).

negative output gap in the new Member States.

Besides highlighting the different cyclical Graph II.2.6: FDI stocks in the new Member States and

developments between the old and new Member economic growth of selected old Member States

States, the substantial positive output gap in the 2.0 P corre l ation: 0.33

new Member States following their EU accession D NL G 5

shows that part of the acceleration of growth was 0

0 1.5 p it

a

-2

cyclical and, thus, temporary. a c 0 0

2

e r , 2 1.0 AT DE FI th FR

 i n

 p

w

2.4.2. Institutions, integration and growth n

g e g r o

0.5

C h

a LU

A key driver of growth was institution building. 0.0

Institutional reforms introduced by the adoption -50 0 50 100 150 of the 'acquis communautaire' have improved the UK -0.5 IT

regulatory framework and increased the

effectiveness of public administration in the new -1.0 IE

Member States. The resulting rise in trade and Growth i n FDI stocks (i n % of GDP) i n NMS -1.5 he l d by se l e cte d O MS countri e s, 2002-2005

investment, including FDI inflows associated

with technology transfers, together with growing Source: Eurostat, Commission services

EU transfers, strengthened the growth performance in the new Member States (Box

II.2.2). It is estimated that accession gave the

new Member States an extra growth boost of Graph II.2.7: Trade with the new Member States and economic

around 1¾ % on average each year during the growth of the old Member States

period 2000-2008( 5 ). This compares favourably 2.5 correl ation: 0.40 with the Commission services’ ex ante estimate 0 0 5 2.0 DK in 2001 of 1.3% additional growth in a central -2 a p it

a NL

scenario, but falls short of the 2.1 % proposed in 0

0 2 e r

 c

, 2 1.5

an optimistic scenario. n

 p th AT

e i 1.0 DE FI

FR

n g r o w P g

It was not only the new Member States that C h a D LU SE

G 0.5 ES

benefited from enlargement. A simple correlation PT BE analysis indicates that, on average, those old 0.0 -10 0 10 20 30 40 50

Member States with higher growth rates in their EL -0.5 IT UK

FDI and trade activity with the recently acceded

Member States have enjoyed bigger increases in -1.0 IE Growth in trade (in % of total trade) of O MS

their real per capita GDP growth rates. Given the -1.5 cou ntri e s wi th the NMS, 2002-2005 limited availability of bilateral FDI data, the

years 2002 and 2005 - i.e. before and after the Source: Eurostat (COMEXT), Commission services

2004 enlargement round - are considered (Graph

). The change in real per capita GDP growth The correlation coefficient amounts to 0.33 and rates of nine old Member States between 2002 the gradient of the trend line is positive. This and 2005 is related to the growth in FDI stocks appears to confirm the hypothesis that between

(ranked by GDP) held by these countries in the 2002 and 2005 those countries with higher growth in FDI stocks in the recently acceded

Member States experienced bigger increases in

( 6 ) Due to data constraints, the figures for Ireland,

Luxembourg and the Netherlands exclude FDI in

( 5 ) Breuss (2009) estimates that EU integration gains for Bulgaria and Romania. FDI stocks were given preference

Bulgaria and Romania could amount to additional ½ over FDI flows, given the stronger year-on-year percentage point real GDP growth per annum up to 2020. volatility of FDI flows.

European Commission

Five years of an enlarged EU

Box II.2.2: Did EU accession contribute to growth?

Based on an empirical analysis this box finds that indicators for institutional quality, the legal the enlargement process had on average a system, freedom of trade, and the regulatory positive effect on growth for the countries that environment are considered (Acemoglu et al., acceded to the EU after 2004, on top of the effect 2005). played by other explanatory variables. Interestingly, this positive effect remains The aim of the analysis is to assess, whether on significant also after controlling for institutional top of the effect of explanatory variables, new factors that are possibly related to accession like Member States performed differently during and freedom of trade, and quality of legal and after accession. Dummy variables capture the regulatory system. This suggests that TFP growth idiosyncratic effects of time periods and of improvements associated with accession-related country groups. There is agreement that much of factors, like FDI and technology transfer, could the enlargement-related growth effects took place have played a relevant role. already before the official accession date, (e.g., Schadler et al., 2006). Hence, the interaction of While the empirical growth literature is the post-2000 dummy with a new Member States extensive, only a few studies have used growth dummy is used to assess whether enlargement regressions to analyse the impact of EU accession affected the growth rate of new Member States. on growth. Crespo-Cuaresma et al. (2002) make explicit reference to EU membership in Following standard practice in the estimation of explaining growth, analysing pre-2004 accessions growth regressions, annual observations are and finding the length of EU membership to have converted into averages over five-year, nona significantly positive effect on economic overlapping sub-periods, in order to avoid that

growth. Schadler et al. (2006) analyse advanced 2 short-term disturbances affect results( ). Results

and emerging market countries and find that with and without institutional variables are income levels, population growth, investment, reported, respectively, in specification (1) and (2) openness and institutional quality determine in Table 1. The explanatory variables have the growth. Falcetti et al. (2006) and Iradian (2007) expected sign and most of them are statistically focus on the growth experience of transition significant. The new Member States appear to countries and find a significant impact of perform significantly worse compared with the institutional factors and transition reforms, as benchmark country group (old Member States) well as a significant impact of recovery from and period (1995-1999) during transition (1990-

transition-related output losses. 3 1994), but significantly better thereafter( ). The

new Member States experienced after 2000 a The panel dataset comprises annual observations significant "growth premium" of 3.3% on top of of 62 advanced, emerging, and transition the OMS beyond the standard growth factors. As economies from 1960 to 2008. Besides the 27 EU for the absolute size of such growth premium, it Member States and the remaining 11 OECD amounts to about 2.1%, and it is obtained as the countries, 24 additional middle-income countries sum of the increase in the growth difference with are considered. Explanatory variables include the OMS compared with the baseline period standard 'textbook' growth determinants (Barro (3.3%) and the change in EU-15 growth over the and Sala-i-Martin, 2004; Levine and Renelt, 1992 same time interval (-1.1%). If the quality of the and Temple, 1999), namely per capita GDP, legal system, freedom of trade, and the quality of population growth, investment, openness, termsregulation in product, labour, and financial

of-trade growth( 1 ). In addition, transition-related

structural change and developments in world commodity prices, are captured by terms of trade ( 2 ) Due to missing data for several variables for the changes (Iradian, 2007). Furthermore, various 2006-2008 period, the last sub-period includes the

available years between 2000 and 2008.

( 3 ) In all regressions, the omitted regional dummy is

that for the OMS, while the omitted period dummy

( 1 ) Results including human capital formation variables is the 1995-1999 period. Hence, the reported

are not shown. For New Member States, only few dummies represent the difference with respect to the

observations are available for this variable. OMS in the 1995-1999 period.

(Continued on the next page) Chapter II

Five years in the EU: achievements and experiences

Box (continued)

markets are added among the explanatory falling short of them), others appear to challenge variables (specification (2)), the impact of somehow expectations (e.g., Slovakia, after accession appears to be reduced, although controlling for its comparatively high investment remaining largely significant. The growth rate and high scores in terms of regulation difference with respect to the old Member States quality, appears to perform worse than predicted). in relation to the baseline period is 2.6% and the absolute increase in growth for new Member Table 1: Growth regression for EU accession States after 2000 amounts to about 1.7%. (1) (2)

Log initial per capita GDP -1.50*** -2.16*** (-5.30) (-7.55)

Graph 1: Actual and predicted growth of real per Population growth 0.21 -0.42**

capita GDP (1.07) (-2.20) Gross capital formation 0.17*** 0.17***

10 Ave rage annual growth, % change (5.73) (6.95)

(2000-2008)

9 Openness 0.01*** 0.01**

Actual growth (3.85) (2.36)

8 Terms of trade growth 0.22*** 0.15***

(4.56) (3.47)

7 Pre dicte d growth (e sti mate d from

spe ci fication (2) in Table 1) Quality of legal system 0.27**

(2.52)

6 Freedom of trade 0.11 5 (0.84)

Quality of regulation 0.46**

4 (2.59)

NMS-OMS growth difference 1995-1999 -1.72 -1.47* 3 (-1.81) (-1.95)

NMS-OMS growth difference: -3.29*** -0.77

2 1990-1994 versus 1995-1999 (-2.65) (-0.72) 1 NMS-OMS growth difference: 3.31** 2.64**

2000-2008 versus 1995-1999 (2.65) (2.67) 0 OMS growth difference; -11.3 -0.95

LV EE LT BG RO HU S K C Z PL SI 2000-2008 versus 1995-1999 (-1.43) (-1.55)

Sample size 300 275 Source: World Development Indicators Adjusted R² 0.46 0.49

Note: Estimation method: OLS. t statistics are reported in parentheses. The panel structure employs non-overlapping five

Average results mask non-negligible differences year periods, except for the last sub-period which includes the

across countries. Graph 1 plots the actual and the available years from 2000. *, **, *** denote statistical

predicted growth rates for 2000 onwards. The significance at 10, 5, and 1 per cent level. Specifications include world region dummies, time period dummies (1995-1999 period

difference between the two represents the average omitted), and the interaction between the two set of dummies. regression residuals. It is visible that there are World regions are defined as follows: OMS (omitted), NMS,

non-negligible deviations of country non-EU OECD, non-EU non-OECD. Dependent variable: Growth in real GDP per capita (PPS, %).

performances from model predictions. Some of Source: World Development Indicators; Penn World Tables;

the results easily meet the intuition (e.g., Latvia Quality of legal system, Freedom of trade and Quality of

and Lithuania exceeding model predictions, while regulation computed by Fraser Institute

Hungary and Czech Republic

their economic growth rates. Similarly, exports expected main beneficiaries of enlargement - plus imports of all the old Member States were score rather poorly in terms of their trade ranked by total trade and plotted against real per performance with the new Member States. capita GDP growth (Graph ); this gave a However, the low growth rates of these countries

correlation coefficient of 0.40( 7 ). It may be are partly due to the fact that they had already

surprising that Austria and Germany - two of the increased their trade volume with the recently acceded Member States prior to enlargement. Nonetheless, the positive correlation seems to suggest that higher trade shares with the new

( 7 ) Alternatively, the same exercise was conducted with

bilateral trade scaled by GDP, yielding a correlation Member States were linked to bigger increases in

coefficient of 0.62. When increasing the time window for growth rates between 2002 and 2005.

both trade specifications to 2000-2007, the corresponding correlation coefficients amount to 0.16 (bilateral trade scaled by total trade) and 0.26 (bilateral trade scaled by GDP).

European Commission

Five years of an enlarged EU

2.4.3. Nominal convergence replaced Finland in the group of three countries with the highest current account surpluses, the

Although the average annual HICP inflation and other two being Luxembourg and the general government deficits (in GDP terms) in Netherlands.

the new Member States decreased from 9% and

4.4% respectively in 1999-2003 to 4.7% and Short-term nominal interest rates declined 2.9% in 2004-2008, they remained substantially substantially in the new Member States from above the HICP inflation and general 12.5% in 1999-2003 to 5.5% in 2004-2008, but government deficit levels of the old Member they also decreased slightly in the old Member States which, over the same time span, rose from States from 3.8% to 3.5%. Lower interest rates 1.9% and 1.3% to 2.4% and 1.8% respectively have stimulated investment and thus growth (Graph II.2.8). (Box II.2.3). Among the new Member States, the

Czech Republic, Lithuania and Malta

Graph II.2.8: Nominal convergence in the enlarged EU experienced the lowest interest rates and

14 % Romania, Hungary and Latvia the highest short

12

10 term interest rates in the post-accession period;

8 NMS this can largely be attributed to the difference in

6

O MS inflation levels in these countries. Among the old

4

2 Member States, the non-euro area members

0 faced higher interest rates than the euro area -2 members both before and after enlargement; the

-4

-6 exception was Sweden, which enjoyed the lowest

% of GDP

-8 short-term interest rates in the post-enlargement 99- 04- 99- 04- 99- 04- 99- 04- period thanks to more moderate price

03 08 03 08 03 08 03 08 developments.

Inflation Short Public C urre nt te rm int. se ctor account

rate s balance balance 2.4.4. Stabilisation costs

Source: Commission services Sacrifice ratios, which relate changes in output

gaps to changes in core inflation, can give an

In the five years after EU accession, average idea of the relative costs of stabilisation.

annual HICP inflation was still at 5% in Latvia,

Romania, Bulgaria, Hungary and Estonia. Over Graph II.2.9: Sacrifice ratios in the old and new Member States

the same time span, the average general 0.4

government deficit remained above 3% of GDP Sacrifice ratio (SR) O MS NMS

in Hungary, Poland and Malta. 0.3

While the average current account deficit 0.2

remained in balance in the old Member States, it

deteriorated in the new Member States from 0.1

4.5% of GDP in 1999-2003 to 6.2% of GDP in

2004-2008, with all recently acceded Member 0.0

States experiencing current account deficits in

both the pre- and post-accession periods. SR = (O Gt – O Gt-1)/(CIt – CIt-1) -0.1 whe re O Gt stands for output gap

Following the 2004 enlargement, the average and CIt for core inflation in time t

current account deficit exceeded 10% of GDP in -0.2

the three Baltic countries, as well as in Bulgaria 99-03 04-08 and Romania. Source: Eurostat, Commission services

Of the old Member States, Greece, Portugal and After enlargement, the sacrifice ratios fell in the Spain recorded the highest current account new Member States, which could be attributed to deficits in both the pre- and post-enlargement the greater credibility of economic policy. The

periods, while after enlargement Sweden

Chapter II

Five years in the EU: achievements and experiences

Box II.2.3: The impact of a decrease in external spreads

This box presents the results of a simulation 8%. In addition, the positive future income exercise assessing the potential impact of a prospects along with the cheaper access to decrease in external spreads on the economies of foreign funds contribute to a 2% increase in new Member States. The results confirm that households' consumption. At the same time, the some of the trends observed since enlargement higher demand along with the enhanced may be attributable to the fall in the costs of consumption smoothing facilities also lead to financing in these countries. persistent current account deficits as domestic inflation rises in the short run. The model Over the past years, a number of observers have generates a peak current account deficit of 2.5% noted that the market perception of risks in new as implied by the 100 basis points fall in the EU Member States was fairly benign. Analysts spread. pointed out that around EU accession, external risk premia fell significantly in these countries The current reversal in market sentiment has led and that this fall could not be directly linked to to an increase in emerging market spreads in economic fundamentals. An IMF study general and also to a rise in the external risk (Luengnaruemitchai and Schadler, 2007) premium on new Member States' yields. This estimated a steady 50-100 basis points advantage may be expected to imply negative effects of new Member States relative to other emerging symmetrical to the ones described above. In markets with comparable fundamentals between particular, the increase in spreads requires a 2003 and 2007. At the same time, the new correction of the external debt stock and therefore Member States also experienced relatively high leads to a reversal in the external balances. These growth and high external deficits as well as a real adjustments lead to a fall in investment and appreciation of their currencies around the date of household consumption. accession. These trends have been reversed recently. Graph 1: Impact of a 100 basis points reduction in

external spreads

Using the Commission services' dynamic general 11 % from

equilibrium model QUEST III to analyse how 10 basel ine much of these observed economic trends may 9 reasonably be attributed to the fall in spreads, the 8

impact of a permanent 100 basis points reduction 7

GDP

in the external spreads is stimulated in a stylised 6

Consumption

5 Investme nt

small open economy. 4 Cu rrent account

3

 The simulation results suggest that the fall in the 2 spreads can explain an increase in GDP by 1

around 1.4% after 5 years, or equivalently, a 0.25 0 percentage point additional growth on average -1 04 05 06 07 08 per year following the shock (Graph 1). This -2 growth is fuelled by the decreased costs of capital -3 which allows a rise in investment by around Source: Commission Services

sacrifice ratios in the old Member States actually Hence, so far the EU Member States appear to became negative in the post-enlargement period, have benefited from lower costs of stabilisation indicating that lower inflation was linked to in the post-enlargement period than in the prestronger growth, which implied that in this enlargement period. period there was no cost of inflation reduction in terms of growth in the old Member States.

• 3. 

  DOES THE EU MAKE A DIFFERENCE?

The remarkable growth performance of the new trade, exchange rate policies and quality of Member States during the last decade, and institutions. particularly since their accession to the EU, has captured the interest of both researchers and policy makers in order to be able to identify and 3.1. ECONOMIC INTEGRATION IN ASIA understand the underlying drivers of economic growth as well as the contribution of trade Although the first integration efforts in Asia date linkages, FDI inflows and institutional factors to back to the 1960s, the progress of regional this performance. Economic growth in the new economic integration has been somewhat uneven Member States picked up significantly at the end (Box II.3.1). The 1997 crisis lent a new impetus of the 1990s showing trends similar to the to the process of economic integration and spectacular performance of the economies of regional financial cooperation, but the concrete East and Southeast Asia. results have been limited. Economic integration

has taken place mainly via the rapid expansion of The newly industrialised economies of this intra-regional trade and the remarkable growth of region (Hong-Kong, Singapore, South Korea and supply-chain networks. However, from an Taiwan), as well as the middle income institutional point of view, integration has been economies of ASEAN (Brunei, Indonesia, largely uncoordinated, mainly focusing on trade Malaysia, the Philippines and Thailand) provide agreements, currency swap arrangements among an interesting benchmark for assessing the central banks or initiatives to create regional economic performance of the new Member bond markets, with often overlapping

States ( 8 ). The selected fast-growing Asian memberships and ultimately limited

economies and the new Member States share commitment. comparable per capita income levels and have both been involved in regional integration The rationale for Asian countries to pursue processes. Moreover, just as the start of regional integration has often been a dual economic transformation at the beginning of the strategy of strengthening the domestic economy 1990s represented a structural break for the new while promoting export growth, including market Member States, the 1997 crisis represented a diversification. In the wake of the 1997 Asian similar turning point for the countries of East and crisis, this strategy partially reflected the view

Southeast Asia ( 9 ). that deeper trade integration with the other

economies of the region would help to further The first part of this section provides an insulate the Asian economies against shocks. The overview of the process of economic and slowdown in multilateral trade liberalization has financial integration in Asia and compares the added to the perception that free trade catching-up experiences in Southeast Asia and arrangements would be an effective means of the new Member States. The second part maintaining a strong export performance. discusses similarities and differences in the Initially, the focus of Asian countries was on respective growth models by analysing the their major trading partners (United States, Japan differences in savings and investment patterns, and China), with other countries being regarded

as gateways to potential markets to help export diversification and obtain preferential access to certain import goods. Therefore, several free

( 8 ) The other ASEAN member countries (Cambodia, Laos, trade arrangements have been negotiated with the

Myanmar and Vietnam) were excluded from the sample

either due to the limited availability of statistical data or Gulf Cooperation Council as well as with Latin

their stage of economic development. American and African countries.

( 9 ) The newly industrialised Asian countries and the selected

ASEAN countries constitute a heterogeneous group in Regional trade integration in Asia can be

terms of per capital income levels. The former can be

considered as a good benchmark for Cyprus, Malta, partially explained by the importance of vertical

Czech Republic and Slovenia while the ASEAN specialization of global production (Athukorala, economies constitute the benchmark for the rest of the 2006). International product specialisation and

new Member States. the fragmentation of production and assembly

Chapter II

Five years in the EU: achievements and experiences

Box II.3.1: Regionalism in Asia

Integration in East and South-east Asia mainly The only concrete proposals for co-operation so evolves within three regional frameworks: far relate to the creation of a 16-nation free trade ASEAN, ASEAN+3 (ASEAN plus Japan, China area and energy security. and Korea) and the East Asia Summit (EAS). These arrangements may provide some flexibility ASEAN is currently the most advanced at the initial stages of integration, but in framework for integration in Asia. Established in conjunction with political competition among 1967, ASEAN now includes ten countries of East many Asian countries, regional integration in this and Southeast Asia (Brunei, Burma/Myanmar, region resembles more to an Asian noodles bowl. Cambodia, Indonesia, Laos, Malaysia, the By 2007, there were 36 free trade arrangements Philippines, Singapore, Thailand and Vietnam). concluded, 41 under negotiation and 24 proposed. Over the past years, its integration process has East Asia is at the forefront of free trade gradually evolved. An ASEAN Free Trade arrangements in Asia, as the initiatives at various Agreement (AFTA) is now in place, with reduced stages constitute more than half of Asia's total tariffs applying to some 95% of intra-ASEAN free trade initiatives. (Kawai, 2007) trade. In 2007, the ASEAN Summit agreed on the creation of an ASEAN single market by 2015, Moreover, there are several intra-regional five years ahead of schedule, to better cope with groupings such as APEC (a Pacific-wide forum) the competitive pressure from China and India. or ASEM (a forum for dialogue between Asia and Europe) and economic fora, such as EMEAP Since its creation in 1997, the main aim of the (the Executives’ Meeting of East-Asia Pacific ASEAN+3 has been to provide a framework for Central banks), which also foster regional closer cooperation in East Asia. Results have so integration. From the perspective of exchange far been limited to co-operation mainly in the rate and monetary policy coordination, EMEAP, financial area. Created in 2005, the East Asia which includes the central banks of Australia, Summit constitutes the most recent initiative to China, Philippines, Hong-Kong, Indonesia, promote closer integration in East and Southeast Japan, South Korea, Malaysia, New Zealand, Asia. EAS membership is wider than ASEAN+3 Singapore and Thailand, is particularly important (it includes ASEAN+3 plus India, Australia and since it aims at enhancing financial and monetary New Zealand) and it is a much looser forum for monitoring, developing financial markets within cooperation than ASEAN or ASEAN+3. It is not the region and encouraging co-operation on yet clear how EAS will evolve in the future. operational and institutional central banking issues.

within vertically integrated production processes with 20.5 % in Thailand, 36.3 % in Malaysia, across borders have contributed to major 59.6 % in the Philippines and 45.2 % in increases in trade integration, particularly in East Singapore.

Asia (Hummels, Ishii and Yi, 2001).

While economic integration has been at the By 2000, for instance, the market share of East forefront of the integration efforts in Southeast Asia in the world trade of intermediate goods Asia, regional financial integration has lagged was the largest among developing countries behind considerably. Cross-border financial (roughly 39.5 % of the exports of these goods). flows between Asian and non-Asian countries However, the importance of exports of are more important than intra-regional financial intermediate goods for the East Asian countries flows within Asia (Cowen et al., 2006). In the is uneven, as Indonesia’s share, for instance, is absence of comprehensive bilateral data on relatively small. Using disaggregated data, cross-border financial flows in Asia, indirect Athukorala (2006) showed that, in 2003–2004, measures (such as the correlation of consumption exports of parts and components accounted for growth) show relatively low correlation levels 9.1 % of the exports from Indonesia, compared between most Asian countries and other Asian

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Five years of an enlarged EU

countries, indicating a low level of intra-regional variables mentioned were less correlated with

financial integration (Mercereau, 2006). those of the other East Asian countries.

Therefore, Asian countries cannot reduce the

volatility of consumption because risk sharing by Using a dynamic factor model and a time horizon

holding assets from other Asian countries is still of almost 30 years (1975-2003), Moneta and

limited. Rüffer (2006) examined the synchronisation of

growth dynamics in the East Asian region,

Intra-regional cross-border banking flows within concluding that growth in East Asia shows a

Asia appear to play a limited role. Using a significant degree of co-movement. They

gravity model to study the gross cross-border identified co-movements in exports as a

banking flows of BIS reporting banks, significant explanatory factor for the co

Eichengreen and Park (2005) concluded that the movement in East Asian economies. Their

different levels of financial market development analysis also suggests that the Asian countries

(measured by bank credit as a share of GDP) are only slightly affected by developments in

compared with other regions largely explain the continental Europe (France, Germany and Italy),

lower level of financial integration in Asia. US and Canada. However, the Asian countries,

do seem to influence European growth to some

In spite of this rather low level of financial extent and, to a lesser degree, economic growth

integration, the success of the European in the US and Canada.

integration initiatives, the adverse effects of the

Asian financial crisis and the unsuccessful

attempts to reach an agreement on the formal 3.2. CATCHING-UP IN THE NEW MEMBER

coordination of exchange rate regimes have STATES AND ASIA

triggered a number of new initiatives aimed at

strengthening the regional financial architecture Both the Southeast Asian countries and the new

in Asia. In May 2000, for instance, the ASEAN Member States have grown more rapidly and

member countries agreed on a liquidity support more steadily than any other regions in the world

facility as part of the Chiang Mai initiative, over the last decade. Due to the ever-closer trade

aimed at addressing short-term liquidity and financial linkages with the old Member

shortages in cases of financial crisis or States in the run-up to accession, the new

contagion ( 10 ). Member States have been able to achieve better

economic performances than other emerging Increasing trade ties between Asian economies economies with similar income levels. have also brought about an upward trend of synchronisation of business cycles, particularly However, the new Member States and the for the newly industrialised Asian economies. selected Asian countries have gone through Analysing ten East Asian and two South Asian catching-up experiences, which differ countries based on data for the period 1967- significantly in terms of their timing and speed, 1997, Shin and Wang (2003) identified intrareflecting differences at the political, economic industry trade as the main driving force behind and institutional level. While in the new Member the synchronisation of business cycles of East States, the process of catching-up with the per Asian economies. Kawai and Monitoshi (2005) capita income levels in the EU began in the early found that real GDP growth, consumption and 1990s, against the backdrop of sustained investment were highly correlated among the structural adjustment and macroeconomic major East Asian economies during the period stabilisation efforts, catching-up in East and 1980-2002. Moreover, they concluded that for Southeast Asia began as long ago as the 1950s. the low income ASEAN countries, the real At the outset of the catching-up process, these

economies had a real per capita income of

around or less than one-tenth that of the US.

( 10 ) The Chiang Mai initiative consists of two pillars: the

already existing enlarged ASEAN swap arrangement and In the first stage of the catching-up process, all

the bilateral swap arrangements among eight ASEAN the selected Asian countries embarked on a

countries, China, Japan and South Korea. development path characterised by pronounced

Chapter II

Five years in the EU: achievements and experiences

Box II.3.2: Lessons from the Asian crisis for the new Member States

Against the backdrop of increasingly integrated capital inflows can have a destabilising impact on financial markets and enhanced capital mobility, recipient economies, especially when they are the virulent 1997 Asian crisis provides a number used to finance widening current account deficits. of lessons for policymakers in the converging In 1997, the crisis-stricken Asian economies had economies of Eastern Europe. It demonstrated overvalued currencies which led to losses in that financial imbalances can cause significant competitiveness and large current account distress for the real economy even in economies deficits. The reversal of investor sentiment with apparently sound macroeconomic induced a sudden stop of short-term capital fundamentals (i.e. strong economic growth, inflows which eventually resulted in a lack of robust saving and investment, buoyant export financing of current account deficits. performance). Moreover, the experience of the Asian economies In the most affected Asian economies, high underscores the importance of sound prudential domestic interest rates and limited exchange rate and supervisory measures to maintain financial flexibility contributed to the accumulation of stability and to prevent banks from building-up large unhedged foreign exchange liabilities, significant foreign exchange exposures that can which were used to support excessively high affect their viability. Apart from the sharp corporate debt-to equity ratios. (IMF 2007) The decrease in economic growth, the Asian crisis subsequent currency devaluations, triggered by proved to be extremely costly in terms of the the concerns of investors about unfavourable financial effort needed for the recapitalisation and current account developments and overrestructuring of credit institutions in difficulty. appreciated real exchange rates, eroded the According to IMF estimates, the cost of bank corporate balance sheets loaded with foreign restructuring ranged from 35% and 32.5% of exchange liabilities. GDP in Thailand and Indonesia to 4.5% of GDP in the Philippines. (Williamson 2005) Furthermore, this crisis showed that short- term

inward-orientated economic policies aimed at growth and were able to reduce the income gap increasing agricultural production, improving vis-à-vis the developed economies. By the end of

education and creating a domestic industrial the 20 th century, Hong-Kong and Singapore

structure shielded from foreign competition by reached per capita real income levels between protectionist measures. After this initial "take 70% and 98% of that of the US, South Korea and off" stage, the Asian countries gradually moved Taiwan achieved income levels of roughly 50% from import substitution towards more outwardwhile Malaysia and Thailand reached a level of oriented policies aimed at promoting exports as between a quarter and a third of that of the US. well as attracting FDI and advanced technology.

The impressive economic expansion of the newly Although the countries of East and Southeast industrialised and middle income economies of Asia have favoured a "common core" set of East and Southeast Asia suffered a setback policies to accelerate the catching-up process, (except for Taiwan) in the aftermath of the they display significant differences in terms of painful 1997 Asian crisis (Box II.3.2), as real the extent of government intervention in the GDP growth dropped significantly in Hongeconomy. This ranges from a highly Kong, Indonesia, South Korea, Malaysia and interventionist approach like that of, South Thailand and, to a lesser extent in Brunei, the Korea, for instance, and the explicitly Philippines and Singapore. redistributive approach in Malaysia to the noninterventionist strategy adopted by Hong-Kong Nonetheless, the implementation of or Thailand. Irrespective of the chosen approach, comprehensive structural reforms and these countries experienced high economic stabilisation programmes allowed the Asian

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Five years of an enlarged EU

economies to quickly recover and embark on a dynamic than the Asian economies in the postnew growth path (Graph II.3.1). accession period (Graph II.3.3). Average real per capita GDP in both regions increased more Graph II.3.1: Real GDP growth in selected Asian countries rapidly in the period 2004-2008 compared to

during and after the 1997 Asian crisis 1999-2003, due to a more favourable general

12 Annual % economic climate.

change

8 Graph II.3.3: Catching-up in the new Member States and

4 Southeast Asia, 1999-2008

6

0 %

Re al pe r capita GDP growth Re al GDP growth

-4

-8 4

-12

-16 2 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9 9 7 9 8 9 9

BR HK ID KR MY PH SG TH TW

Source: IMF

0

As with Southeast Asia during and after the 1997 99-03 04-08 99-08 99-03 04-08 99-08 crisis, the current economic downturn is NMS SE Asia

affecting growth in the new Member States. Real Source: IMF GDP growth is expected to slow down significantly in all new Member States in 2009 The catching-up process in the new Member (Graph II.3.2). In Estonia and Latvia, which were States has also been influenced by demographic already cooling down before the financial developments, considering the slower population turmoil, growth is projected to remain in growth in Central and Eastern Europe compared negative territory in 2009. to Asia.

Graph II.3.2: Real GDP growth in the new Member States,

2007-2009 3.3. SIMILARITIES AND DIFFERENCES IN THE

12 Annual % GROWTH MODEL

change 10

8 While both the Asian countries and the new 6 Member States exhibit similarities in terms of the 4 speed of the catching-up process during the 2 period under review, a closer look at the factors 0 that drive economic growth in these countries

-2 reveals significant differences.

-4

-6 3.3.1. The role of foreign and domestic -8 demand 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 0 7 0 8 0 9 BG CY CZ EE HU LV LT MT PL RO SK SI In the new Member States, economic growth has mainly been driven by domestic demand while

Source: Commission services (January 2009 interim forecasts) net exports have contributed negatively to

economic expansion except for the Czech Real per capita GDP and real GDP picked-up significantly in both the new Member States and

East Asia in the period 1999-2008, with the new Member States experiencing a faster catching-up

Chapter II

Five years in the EU: achievements and experiences

Graph II.3.4: Real GDP growth and its composition in the new Member States and Southeast Asia, 2003-2007

20 % GDP growth con tribution of dome stic de m and GDP growth contribution of ne t e xports

15

10

5

0

-5

-10 NMS SE BG C Y C Z EE HU LT LV MT PL RO SI SK HK ID KR MY PH SG TW Asia

Note: No data for Brunei and Thailand; provisional data for 2007

Source: Asian Development Bank

Republic, Hungary and Slovakia during the Singapore and Taiwan), the contribution of net

11

period 2003-2007 (Graph II.3.4)( ). exports to economic growth was higher than in the middle income economies during the period

Rapid growth in consumption and increasing under review (Graph II.3.4). However, the private investment fuelled domestic demand in increased dependence on net external demand all of the new Member States in the period under and domestic investment channelled towards the review. One of the salient features of economic build-up of export capacities may prove growth in these countries has been the vulnerable in the long run. Adverse external impressive contribution of total factor demand shocks or a revival of protectionist productivity, with the countries that experience sentiments among the main trading partners (i.e. higher TFP growth expanding faster. Capital US and EU) may significantly increase the accumulation has also provided a substantial volatility of economic growth in these countries. contribution to growth, albeit lower than in the

Asian economies, while the contribution of 3.3.2. The role of savings and investment

labour has been relatively modest or even negative in some countries (IMF, 2008). The high current account surpluses of the Asian

economies highlight substantial changes in the The analysis of the Asian growth model reveals saving and investment patterns, with the savingssome interesting developments. After the 1997 investment balance moving from a deficit before crisis, the East and Southeast Asian countries the Asian crisis to a significant surplus in the moved from a growth model with a more past few years (Graph II.3.5). While there has pronounced contribution of domestic demand, been an active debate over whether the large large current account deficits and overvalued surpluses in emerging Asia reflect an currencies to an export-led growth model “investment drought” or a “saving glut,” characterized by an increased contribution of net statistical data suggest that this trend reflects a exports and investment directed towards the drop in investment after the intense production of tradable goods, undervalued overinvestment of the early 1990s, rather than a domestic currencies and widening current pick-up in savings. Investment declined sharply account surpluses. In the newly industrialized during the Asian crisis and remained at roughly Asian countries (Hong-Kong, South Korea, 20% of GDP thereafter.

FDI has played only a limited role in explaining ( 11 ) The choice of this time horizon was determined by the the recent sluggish private investment trends in

limited availability of longer time series for the

calculation of real GDP growth and its composition for Asia. For most Asian countries, FDI accounts for

the Asian economies. a relatively small fraction of total investment.

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Five years of an enlarged EU

Moreover, average annual FDI inflows expressed same time, investment increased slightly in in USD remained virtually unchanged in the 2004-2007 compared to 2000-2003 (Graph post-crisis years compared to the pre-crisis years II.3.5). Overall, the negative savings-investment for several middle income Asian economies, balance reveals a certain dependence of the new while for the newly industrialised countries Member States on foreign savings to finance the

(Hong-Kong, Singapore and South Korea) these buoyant investment activities (see Chapter IV). inflows have continued to increase. Only

Malaysia has recorded a small decline, but in 3.3.3. The role of trade

relation to GDP this trend already began in the early 1990s. The new Member States have benefited from their proximity to Western Europe and their Low investment in the post-crisis period may be orientation toward these markets, which has explained by the increased investment risk, and reduced their exposure to external shocks. The also by the difference in performance between goal of EU accession became one of the key tradable and non-tradable sectors. According to driving forces behind the structural adjustment the IMF (2006b), one of the sources of the postand reform efforts. All the new Member States crisis investment decline is the financially joined the World Trade Organization (WTO) starved producers in the non-tradable sector. soon after the beginning of the transition process. They have ranked highly in the EBRD index of Graph II.3.5: Savings and investment in the new Member States liberalization of trade and foreign exchange

and Southeast Asia systems, and in terms of the IMF Trade

40 % of GDP Restrictiveness Index most are on par or even less restrictive. Moreover, the new Member

Ave rage inve stme nt States have shifted the composition of exports

30

Ave rage savings toward areas where they expected to have comparative advantage, such as textiles and

20 natural resources, and most are experiencing a

rapid development of FDI-induced, intraindustry trade in areas such as automotive

10 production and electronics.

Graph II.3.6: Intra-regional trade in the new Member States 0 and Southeast Asia

00-03 04-07 00-03 04-07 25

NMS SE Asia % of total

trade Note: The different time horizon is determined by the lack of forecast 1999 2007 data for the Asian countries for 2008. 20

Source: IMF

Companies in the tradable sector have better 15

access to international capital markets while the smaller companies in the non-tradable sector rely 10 predominantly on domestic bank credit. Since the 1997 crisis, the companies in the non 5 tradable sector have been the most affected and have benefited only marginally from subsequent

exchange rate depreciations due to their 0 NMS SE Asi a orientation towards the domestic market. Note: No data for Brunei.

Source: IMF

After a strong rebound from the sharp decline at

the beginning of transition, savings rates have For the past four decades, trade has been the been relatively stable (roughly 18% of GDP) in main engine of economic growth in most of East the new Member States in recent years. At the and Southeast Asia. While unilateral

Chapter II

Five years in the EU: achievements and experiences

liberalisation of trade helped to initiate the they have moved from a soft US dollar peg export-led development in the region, increasing towards a shadowing of the Chinese renminbi. economic integration has been a significant factor in supporting growth in this region. Despite vigorous intervention by the central Vertical intra-industry trade has been fostered by banks, the currencies of the Asian countries have the reduction in the cost of transportation and been under significant appreciation pressures in communication, by technological progress and recent years. Since the end of 2004, a simple by the strategic decisions of multinational average of exchange rate indices for emerging companies to reallocate certain stages of Asia indicates that local currencies have production processes to lower-cost countries. appreciated by over 5%. Excluding Hong-Kong,

which has a currency board arrangement, the In the period 1999-2007, regional export shares appreciation over the past two years has been have exhibited a rising trend in both the new closer to 7%. There have been considerable Member States and Asian countries (Graph differences between these countries, as some of II.3.6). The relatively low importance of trade them (notably the Philippines, South Korea, and among the new Member States may be explained Thailand) have experienced a more rapid by their strong orientation towards the other EU appreciation. countries, because their main trading partners are the old Member States. As trade is an important In general Asian economic policy-makers still channel through which economic shocks are exhibit a "fear-of-floating" vis-à-vis the US transmitted, export-oriented growth strategies dollar. This policy is partly driven by the desire tend to make countries more dependent on to maintain relative price competitiveness against worldwide economic developments. The rapid regional competitors such as China. With more expansion of intraregional trade in emerging flexibility of the renminbi other Asian countries Asia could therefore suggest that its dependence could follow suit. Greater exchange rate on the rest of the world is diminishing. However, flexibility would also allow increasing capital that depends partly on how much of the rise in account convertibility and potentially a reduction intra-regional trade is driven by increased in the current account surpluses and of the domestic demand which is independent of sizeable reserves of many Asian countries. external demand from outside the region, for Increasing exchange rate flexibility could thus which the evidence is not clear-cut. help Asian economies to address the mounting

costs of excess foreign exchange reserves such as

3.3.4. The role of exchange rates quasi fiscal costs, potential capital losses or the

restriction of monetary policy. As reserve There is a broad consensus among economists increases have been only partially sterilized, that the soft US dollar pegs favoured by several credit growth has not been reigned in completely. Asian countries prior to 1997 contributed to the This has also fed into the creation of asset Asian crisis. However, there is far less agreement bubbles such as property or stock exchanges and on the types of exchange rate regimes of many has contributed to global imbalances.

Asian countries since the crisis. Malaysia unambiguously pegged its currency to the US Similar to the Asian countries, the new Member dollar, while other countries (e.g. South Korea States also display significant differences in their and the Philippines) officially proclaim to have choice of exchange rate regimes, ranging from adopted floating exchange rates. Thailand opted adoption of the euro (Slovenia, Cyprus, Malta, for inflation targeting while Singapore adopted Slovakia) and currency boards managed floating with no pre-determined path arrangements/hard pegs (Baltic countries and for the exchange rate. There is a burgeoning Bulgaria) to inflation targeting frameworks literature showing that there can be a significant (Czech Republic, Romania) or independent divergence between de facto and de jure floating (Poland). Irrespective of the exchange exchange rate regimes. Moreover, there is still rate regime, the new Member States have considerable debate on how flexible Asian experienced a considerable appreciation of the currencies have become in reality, or whether real exchange rate, which has led to a loss of cost

competitiveness in the period 1999-2008. In

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Five years of an enlarged EU

contrast to the Asian countries, in the new Graph II.3.7: Bertelsmann Transformation Index for the new

Member States there is no divergence between Member States and Southeast Asia the announced and the de facto exchange rate 10 Ave rage score s NMS SE Asi a regimes. 8

While the currency board arrangements/hard 6 pegs were originally adopted with the aim of

4

fostering macroeconomic stability, in recent years they have increasingly contributed to rapid 2 credit expansion fuelled by capital inflows,

increasing real estate prices and rising current 0 0 3 0 6 0 8 g e 0 3 0 6 0 8 e 0 3 0 6 0 8 e 0 3 0 6 0 8 e

account imbalances. The new Member States r a r a

g

r a

g

r a

g

v e v e v e v e

pursuing more flexible exchange rate regimes A A A A Status Inde x Pol i ti cal Econ omi c Manage me nt

have been better equipped to avoid the transformati on transformation In de x unwarranted results of increasing capital inflows Note: No data for MT, CY, BR and HK; the scores for the status and

and to adjust to a real appreciation of the management index range from 0 (serious obstacles for a market-based democracy) to 10 (consolidated market-based democracy or in a

exchange rate via nominal appreciation. course of consolidation).

Source: Bertelsmann Foundation

3.3.5. The role of institutions The results of the status index, which represent

Country-specific factors such as the rule of law the mean value of the scores for political and (enforcement of property rights, fight against economic transformation, reveal that the new corruption), good governance and the quality of Member States are considerably more advanced institutions can influence growth and in their development towards a market-based development through their impact on the democracy than the Asian countries. This allocation and productivity of resources. To outcome can be seen as a corollary of the efforts foster economic performance, public policies of the new Member States to fulfil the political, have to pursue actions that enforce property legal and economic criteria for EU accession and rights, ensure good governance and enhance both to achieve increased nominal and real the efficiency of the legal system and the quality convergence with the old Member States in the of the institutions. Several studies provide some post-accession period (Graph II.3.7). The empirical evidence on the correlation between management index also confirms this pattern, as the rule of law and the growth of per capita the new Member States have higher scores for income as well as on the growth-promoting stability and the pursuit of reforms than the

impact of participatory and decentralised Asian countries.

political systems (Rodik, 2000). The Index of Economic Freedom published by

The Bertelsmann Transformation Index is one of the Heritage Foundation, which assesses the the indices that provide a systematic insight into degree of economic freedom by looking at a key parameters of policy-making, by examining complex of variables such as business freedom, the development and transformation processes in trade freedom or property rights, indicates that the countries analysed. (Bertelsmann Foundation, all new Member States with the exception of 2006) The Bertelsmann Transformation Index Poland are mostly free or moderately free consists of two sub-indices: the status index and economies. In the period 1999-2008, Bulgaria, the management index. While the status index Romania, Slovakia and Slovenia have gradually shows the state of development towards moved from a mostly unfree or repressed democracy and market economy, the economic environment to a moderately free management index assesses the dynamic factors economic environment. The East and Southeast of good governance, especially reforms aimed at Asian countries did not experience any changes achieving a market-based democracy. in the period under review, as Indonesia and the

Philippines are still the countries with the lowest

degree of economic freedom.

Chapter II

Five years in the EU: achievements and experiences

The Corruption Perception Index published by

Transparency International shows that since

1999, the new Member States have made steady progress in reducing corruption. With the exception of the Philippines and Malaysia, the countries of East and Southeast Asia display a similar trend. As a matter of fact, Singapore and

Hong-Kong are currently in the group of the less corrupted countries of the world.

3.4. CONCLUSION

While both the new Member States and the East and Southeast Asian economies have been at the forefront of global growth, they display significant differences in terms of their growth models, drivers of growth and institutional factors. Due to the higher contribution of domestic demand to growth compared to the selected Asian economies, economic growth in the new Member States appears to be more sustainable in the long run as it might be less sensitive to the adverse shocks that may affect foreign demand. Concerning the contribution of institutional factors, the new Member States had to implement sound macroeconomic and structural policies in the run-up to EU accession.

Furthermore, the existing EU policy framework contributes to a further strengthening of macroeconomic fundamentals and to reducing uncertainty. Institutionally, East and Southeast

Asia is clearly lagging behind the new Member

States. However, the lessons learned from the

Asian crisis and the success of European integration has lent impetus to the efforts to strengthen this aspect and to move forward with regional integration (e.g. Chiang Mai initiative,

ASEAN single market project).

Chapter III

Goods and services in an enlarged EU

SUMMARY OF MAIN FINDINGS

The change in economic regime in the Central competitiveness caused by the rise in wages in and South-Eastern European economies since the these countries. Nevertheless, the new Member beginning of the nineties eventually leading to States remain very competitive, as wages per accession in 2004 signified the extension of the employee were only 26 % of the EU-15 average principle of the free circulation of goods, in 2007 (14 % in 1999). After a continuing services, capital and persons to a much larger depreciation up to 1999, the nominal exchange area in Europe. This reliance on free markets rate did not play a significant role in determining together with the governance framework the level of cost competitiveness in the new provided by the European Union was the key to a Member States. successful catching-up process which worked to the benefit of not only the new, but also the old These developments are in contrast to the old Member States. In the following chapters these Member States, which lost market share in the issues are examined in detail, starting with trade world (down from almost 39.5 % in 1999 to and the functioning of product markets. 34.3 % in 2007); this should not be attributed to

the new Member States taking the place of the Trade fosters growth, because it allows a country old, but instead reflects the general trend of the to specialise in the production of goods in which emerging economies gaining access to the world it has a comparative advantage. Trade also market. Furthermore, the old Member States promotes FDI which leads to technology transfer post large trade surpluses with the new Member and, more generally, openness is linked to good States. institutions and the implementation of best practices. Over the last decade, trade volumes Contrary to the expectations before enlargement, expanded by 11.3 % in the new Member States - the new Member States did not increase considerably faster than in the old Member specialisation in labour intensive products to take States (5.3 %). In particular, trade with the rest advantage of their low wages. On the contrary, of the world expanded rapidly, suggesting that large-scale foreign direct investment, mainly the common external tariff which the new from the old Member States, has made it possible Member States had to apply did not result in to increase the technological content and quality trade diversion (the substitution of external trade of the export basket of the new Member States. by trade inside a customs union), but that instead trade creation was actually a consequence of the A structural shift towards services and the EU enlargement. knowledge intensive economy has taken place in

the new Member States, even if on average they The level of trade integration is high in the are still lagging behind the old Member States European Union, which receives almost 80% of and several emerging markets outside the EU. the total exports of the new Member States and While business constraints, such as limited 60 % of those of the old Member States. While access to finance and the lack of skilled labour, these overall shares have been broadly stable are reported by the enterprises in the new over the past decade, shifts have occurred within Member States more frequently than by those of these groupings. The new Member States the old Member States, in nine out of the twelve became more important, both for each other new Member States the trend is quite (receiving 19.5 % of their exports in 2007 encouraging. Competition has increased in the compared to 13.2 % in 1999) and for the old new Member States, but on average their firms Member States (where exports to the new attach a great deal of importance to the aspects of Member States increased from 4.7 % in 1999 to the Internal Market (including the elimination of 7.5 % of total exports in 2007). border controls, harmonisation of standards and

– in many Member States - a single currency). The new Member States succeeded in Managers in the new Member States are aware considerably increasing their world market share that the response to the growing competitive from 2 % of global imports in 1999 to about 4 % challenge, which they could not but notice, is in 2007, thanks to a quality upgrading of their quality upgrade (71% are of this opinion in the products and productivity gains which new Member States, compared to 63 % in the old compensated for the sharp drop in cost Member States).

European Commission

Five years of an enlarged EU

Regarding the governance of competition policies, each new Member State has set up a national competition authority responsible for enforcing national law, as well as EU competition rules. Despite significant efforts and general progress, the enforcement of competition law remains a challenge in some of the new Member States. A few Member States are still in the process of adapting their national legal framework to enhance effective enforcement.

While the current level as a percentage of GDP remains higher than the EU-25 average, the new Member States have successfully re-directed their State aid towards horizontal objectives. This process has been reinforced by regional and national development programmes that linked EU funding with Lisbon objectives. A rapid convergence in State aid policies between new and old Member States can be observed. This illustrates the efficiency of the State aid monitoring authorities in the new Member States.

As regards competition in specific sectors, major differences can be observed as a consequence of the regulatory frameworks in place, but data availability is also an issue. A general finding, however, is that through its directives the EU seems to have significantly improved both the regulatory framework and effective competition. This can be observed, inter alia, in the telecommunication and postal services sectors.

• 1. 

  TRADE AND CATCHING-UP

During the last decade increased globalisation quality of exports, focusing on the breakdown of has pushed world trade growth far higher than the export basket by factor and technology the growth in world GDP. Trade has been intensity. boosted by the "slicing up" of the production chain, spreading production phases over a large number of emerging partner countries (Table 1.1. TRADE AND GROWTH

III.1.1). EU enlargement is a special case of

globalisation. Enlargement brought legal 1.1.1. General trends

certainty and institutional stability and abolished intra-EU trade barriers. As a result, large flows In general, trade by both the new and old of FDI, mainly from the old Member States, have Member States grew faster after the 2004 increased the technological content and product enlargement (by 12.8% and 6% respectively) quality of the new Member States' export basket compared to the preceding five-year period. In to an impressive degree. This has allowed new most of the regions in the world, trade grew Member States to almost double their global faster from 2004 onwards, compared to the export market share between 1999 and 2007, preceding five-year period, with the exception of notwithstanding a seemingly large loss in cost China. competitiveness. At the same time, old Member

States lost market share, against the background Table III.1.1: Average growth rates of trade volumes per region

of a far lesser deterioration in cost Annual percentage change 99-03 04-07

competitiveness. OMS 4.4 6.0

NMS 9.4 12.8

In recent years, new Member States have adapted USA 2.7 6.1 Japan 4.5 7.2

the composition of their export basket, in terms Other industrialised countries 2.9 6.1 of factor and technology intensity, to bring it China 22.8 17.6

closer to the composition of exports of the old Asia excl. Japan and China 7.5 9.0

Member States and the world. Research has MENA 9.3 10.1 Latin America 5.4 8.0

shown that similarity in export composition Other emerging countries 2.3 9.1

between the new and old Member States is World trade 5.5 8.7

positively and significantly associated with the World GDP 3.4 4.9 convergence process of new Member States in Source: IMF, Commission services

terms of income. In other words, those new

Member States whose export composition is Interestingly, extra-EU trade grew faster than closer to the structure of the old Member States intra-EU trade after the 2004 enlargement (by enjoy a faster catching-up process. 10.4% compared to 8.7% on average in 2004-

2007). This suggests that the creation of trade

An enlargement that takes place during a period (additional gains due to reduction of trade of increased globalisation is clearly different barriers between the Member States) was from previous enlargements. This can be seen in stronger than the trade diversion effect (losses the rapid increase, albeit starting from a low due to shifts of trade flows from third countries level, in the market share of the new Member towards the Member States).

States after 2004.

In the last decade, the new Member States

The remainder of this section is organised as increased their trade openness, measured as a follows. The first part reviews the literature on ratio of imports and exports to GDP to a greater the relationship between trade and growth. The extent than the old Member States. It should be second part focuses on developments in price kept in mind, however, that the 1990s was the and cost competitiveness in the old and new crucial and most intense period of economic Member States. The third part deals with the transformation in Eastern Europe, when the developments in market share and the Europe Agreements constituted the framework geographical breakdown of trade flows. In for economic co-operation and trade conclusion, the last part analyses measures of the liberalisation between the old and the new

European Commission

Five years of an enlarged EU

Member States. Indeed, it was during this period process of new Member States in terms of that the strongest shift of trade flows from the income. In other words, those new Member new Member States towards the old Member States whose export composition is closer to the States took place. The ratios of both intra- and structure of the old Member States enjoy a faster extra-EU trade to GDP increased continuously catching-up process. Moreover, specialisation in with the stronger growth recorded after the 2004 intra-industry trade stimulates the development enlargement. The increase in intra-EU trade was of higher value-added activities and, thus, the

partly due to the acceleration of trade between catching up process as a whole (Palazuelosthe new Member States. Trade openness for the Martinez, 2007). The product structure of EU old Member States was more stable, and this trade is analysed in detail in the last part of this applied to both larger and smaller Member States section. (Graph III.1.1). Although the most intensive period of trade Graph III.1.1: The importance of intra and extra-EU trade in liberalisation between old and new Member

goods for new and old Member States States took place in the 1990s, when the shift of

50 % of GDP Extra trade flows from the new to the old Member

45 Intra States was particularly intense, the 2004

40 enlargement of the EU lent an additional impetus 35 to the process, as the new Member States became 30 even more integrated into the internal market and 25 incorporated the rules of the common trade 20 policy. However, this one-off effect of trade

15

10 liberalisation, known as ‘static effects’ as defined 5 by Viner, is expected to be smaller than the 0 dynamic effects which occur over the longer

3 7 3 7 3 7 3 7 3 7

-0 -0 -0 -0 term and which are associated with the positive

9 9 0 4

-0

9 9

-0

0 4 9 9

-0

0 4 9 9

-0

0 4

-0

9 9 0 4

-0

impact that trade has on economic growth. Van

NMS EL, ES, DE, FR, AT, FI, BE, DK,

PT IT, UK SE IE, NL den Berg (2006), who presents results of over

130 regression models linking the openness ratio

Source: Commission services (AMECO) with economic growth, finds support for this

hypothesis. He points out that, in general, open 1.1.2. Does trade stimulate growth and, if so, economies grow 2-3% faster than closed

how? economies. ( 12 )

Trade between old and new EU Member States A simple comparison of real GDP growth and can be explained to some extent by traditional openness ratios for EU Member States (Graph trade theories, as a significant part of new III.1.2) shows this positive relationship, even Member States' trade is still based on relatively though the magnitude of the relationship differs

abundant labour and land, while trade by the old from country to country.

Member States with new Member States and

with the rest of the world is concentrated in Although consensus reigns on the positive capital-intensive sectors. However, the impact that trade has on economic growth, increasing share of intra-industry trade streaming despite methodological problems (causality), from the new Member States and the gradual economists are divided over the potential move towards specialisation in more capitalchannels through which trade could affect intensive and high value-added products in some growth. According to the literature on the of the new Member States can only be explained subject, trade enables better allocation of by reference to the new trade theories. resources through increased international

Importantly, with respect to the catching-up process, De Benedictis and Tajoli (2005) argue that similarity in export composition between the

new and old Member States is positively and ( 12 ) Some of the studies use index of openness to trade,

significantly associated with the convergence others use proxies that represent the restrictiveness of trade policies.

Chapter III

Goods and services in an enlarged EU

competition, which results in lower prices and while being exposed to external competition. It better quality. Trade also supports dissemination has two main dimensions: price and cost of know-how and technology, and creates a competitiveness, on the one hand, and non-price better environment for investment. Wacziarg and competitiveness, on the other.

Horn Welch (2008), for instance, find that investment constitutes an important channel To assess developments in price and cost between trade liberalisation and growth, competitiveness, real effective exchange rates are accounting for about 21% of the effect. widely used. The focus of the argument set out

below will be on developments in the real Graph III.1.2: Member States' openness ratios and real GDP effective exchange rates, using as a deflator the

growth, 1996-2007 overall unit labour cost ( 13 ), as this allows the

8

LV issue to be broken down into the developments in EE

7 IE exchange rates, productivity and labour costs

LT (Graph III.1.3). i n % 6

w th SK

r o 5 The graphs show a fairly steady appreciation of PL SI

P g EL the real effective exchange rate of the new

D 4 FI Member States, relative to 36 industrial

a l

G

ES CY

HU

C Z 3

e r

e

RO SE BG UK countries (

14

). Developments in nominal

PT NL

MT

a g FR AT BE exchange rates contributed only marginally to

v e

r 2

DK

A IT DE this appreciation between 2000 and 2007. While

1 y = 0.0377x + 1.8516

R 2 = 0.167 the real effective exchange rate rose by 28%, the

0 nominal appreciation was only 8%. This is partly

20 45 70 95

Ave rage of e xports and imports of goods and se rvi ce s the result of exchange rate policies that are aimed

(% of GDP) at stability vis-à-vis the euro. Before 2000, the nominal effective exchange rate and the real

Source: Commission services (AMECO) effective exchange rate actually moved in

opposite directions. The graphs also show the

A further important aspect of the trade-growth large rise in relative unit labour costs that relationship is advanced by Winters (2004), who boosted the level of the real effective exchange argues that other macroeconomic policies (see rate of the new Member States. An impressive below) and institutions in general are important rise of 19% in relative productivity between in order to fully understand the relationship 2000 and 2007 is dwarfed by a 55% increase in between trade and growth and the catching-up relative labour costs.

process. He underlines that it is difficult to

isolate the pure impact of trade on growth, but By contrast, the relative unit labour costs of the results of a number of policies - such as old Member States were fairly stable between investment policy, the approach towards 2000 and 2007, with a decline between 2% and inflation, education and institutions - are also 3% for both relative productivity and relative positively influenced by openness to trade. In the labour costs. As a result, the evolution of the real case of the 2004 enlargement of the EU, trade effective exchange rate (+9%) of the old Member

liberalization was implemented by new Member

States not as an isolated policy but as part of a package including macroeconomic and fiscal

policies. Therefore, in the broader context, ( 13 ) Depending on the deflator used, developments in the real

openness is a positive force for growth (Baldwin, effective exchange rate can be quite dissimilar. A

2002). difference between the evolution of, on the one hand, the real effective exchange rate based on export prices and,

on the other, the real effective exchange rate based on unit labour costs or GDP deflator indicates differences

1.2. COMPETITIVENESS between relative prices of tradables and non-tradables. ( 14 ) All variables in this section are expressed relative to 36

countries (EU plus Australia, Canada, Japan, Mexico,

Competitiveness is the ability of a nation to New Zealand, Norway, Switzerland, Turkey, US). The

generate relatively high income and employment, average indexes for the OMS and the NMS are calculated with Member States’ GDP in EUR as weights.

European Commission

Five years of an enlarged EU

States largely reflects the development in the mainly due to exchange rate developments, and nominal effective exchange rate (+10%). Germany, which experienced the most favourable development in relative labour costs Graph III.1.3: Real effective exchange rates and their of all EU Member States. Without Germany, the

components cost competitiveness of the old Member States

160 REER 160 NEER would have deteriorated by 12% instead of 9%.

150 2000 = 100 150

140 140 2000 = 100

130 130

120 120 As section 1.3 will show, the new Member States

110 110

100 100 significantly increased market shares between

90 90

80 NMS OMS 80 2001 and 2007, notwithstanding a seemingly

70 70 NMS OMS

60 60 large loss in cost competitiveness. The old 96 97 98 99 00 01 02 03 04 05 06 07 96 97 98 99 00 01 02 03 04 05 06 07 Member States, on the other hand, lost market

160 Relative productivity 160 Relative labour cost

150 150

2000 = 100 share, against the background of a much smaller

140 140 2000 = 100

130 130 deterioration in cost competitiveness. The

120 120

110 110 counterintuitive correlation that was observed

100 100

90 90 between market share developments and price

80 80 NMS OMS

70 70 NMS OMS and cost competitiveness points to other factors

60 60

96 97 98 99 00 01 02 03 04 05 06 07 96 97 98 99 00 01 02 03 04 05 06 07 playing a key role: these factors can be grouped under the heading of ‘non-price

Source: Commission services competitiveness’.

Two caveats apply to the above analysis. First, The non-price competitiveness of an economy is the focus on developments between 2000 and a function of the quality of its products. The 2007 should not divert attention from the quality of a product is the result of its additional enduring attractiveness of the new Member tangible characteristics (such as size or States in terms of absolute labour costs. In 2007, composition) or intangible characteristics (like the average nominal compensation per employee design or reliability) that increase the willingness in the new Member States was 26% of the EU-15 of buyers to pay a higher price for the product. level (14% in 1997). The overall range was from This includes the contribution of production 9% in Bulgaria to 57% in Cyprus, which leads to technology. As Dulleck at al. (2005) have shown, the second caveat: there are big differences several new Member States were successful in within the two groups. These differences can be achieving a substantial quality upgrading of their observed in price competitiveness as well as in export structure. More on the product its components, as shown in the following composition of EU trade can be found in section

paragraphs. 1.4.

Notwithstanding the 28% appreciation of the

average real effective exchange rate of the new 1.3. GEOGRAPHICAL COMPOSITION

Member States between 2000 and 2007, two new Member States managed to record a much

smaller loss in competitiveness - even smaller 1.3.1. Total export market shares than the EU-15 average. The new Member States While the EU enjoys a dominant role as an in question are Slovenia, due to exchange rate exporter on world markets, the pattern of EU developments, and Poland, due to a favourable export market shares reveals some interesting development in relative labour costs. The real characteristics when one tries to make a separate effective exchange rate for Romania, on the other analysis of the new and old Member States in hand, appreciated by 63% following an increase 1999-2007 (Table III.1.2).

in relative labour costs of more than threefold

between 2000 and 2007. The new Member States as a group increased

their market shares in all country groups to

In contrast to the EU-15 aggregate, two EU-15 which they exported in 2007 compared to 1999, Member States improved their competitiveness although the shares are still relatively small between 2000 and 2007: they were Sweden, compared to those of the old Member States.

Chapter III

Goods and services in an enlarged EU

Table III.1.2: Export market shares of new and old Member States

% World Old Member States New Member States Rest of the World

1999 2004 2007 1999 2004 2007 1999 2004 2007 1999 2004 2007

BG 0.07 0.10 0.13 0.10 0.16 0.20 0.14 0.24 0.35 0.04 0.06 0.07

CZ 0.47 0.76 0.88 0.87 1.45 1.70 3.18 3.76 4.22 0.10 0.16 0.21

EE 0.04 0.06 0.08 0.08 0.11 0.12 0.21 0.32 0.36 0.01 0.02 0.04

CY 0.01 0.01 0.01 0.01 0.02 0.02 0.01 0.01 0.01 0.00 0.01 0.00 LV 0.03 0.04 0.06 0.05 0.06 0.07 0.17 0.26 0.47 0.01 0.02 0.03 LT 0.05 0.10 0.12 0.07 0.13 0.14 0.38 0.60 0.76 0.02 0.06 0.07 HU 0.44 0.61 0.68 0.90 1.20 1.23 1.36 2.04 3.03 0.11 0.17 0.22 MT 0.03 0.03 0.02 0.05 0.04 0.03 0.01 0.02 0.01 0.03 0.02 0.02

PL 0.48 0.82 1.01 0.91 1.54 1.90 2.02 2.89 3.67 0.15 0.27 0.34

RO 0.15 0.26 0.29 0.26 0.47 0.50 0.43 0.65 0.94 0.07 0.11 0.13

SI 0.15 0.18 0.21 0.27 0.29 0.35 0.43 0.50 0.76 0.07 0.10 0.09

SK 0.18 0.30 0.42 0.29 0.50 0.73 2.02 2.22 2.71 0.03 0.07 0.09

NMS 2.10 3.28 3.90 3.83 5.97 6.98 10.35 13.50 17.29 0.64 1.05 1.30

OMS 39.49 37.84 34.33 66.67 64.87 61.10 68.95 59.77 58.30 21.08 20.43 18.24

EU-27 41.59 41.12 38.24 70.50 70.83 68.07 79.30 73.27 75.60 21.72 21.48 19.53

US 12.35 9.03 8.51 7.10 5.07 4.99 2.16 1.43 1.51 16.42 12.08 11.17

Japan 7.18 5.95 5.01 3.49 2.54 2.02 1.24 1.45 1.44 9.98 8.45 7.09

China 3.51 6.59 8.94 1.41 3.00 4.63 1.30 2.65 3.85 5.05 9.17 11.93

Brazil 0.88 1.10 1.30 0.56 0.65 0.82 0.30 0.38 0.29 1.13 1.44 1.67 Mexico 2.51 2.13 1.91 0.23 0.18 0.30 0.10 0.03 0.07 4.17 3.53 3.01 Oth.L.Am. 2.19 2.18 2.79 0.92 0.84 1.19 0.28 0.32 0.41 3.15 3.17 3.94

Source: Eurostat (COMEXT)

This confirms that, generally, the new Member new Member States almost doubled their world

States were able to improve their international market shares between 1999 and 2007. By competitiveness thanks to their transition contrast, Malta lost market share over the period

dynamic during the last decade. under review( 15 ). In general, the rapid increase in

the market shares of the new Member States after Graph III.1.4: Export market share after EU accession (extra 2004, although starting from a low level, was

EU) strongly supported by the globalisation process,

160

100 = l e ve l i n fi rst ye ar of EU Me mbe rship which could partly explain the difference in

market share gains compared to previous 140 enlargements (Graph III.1.4).

PT

120 The trend in the export market shares of the old EL Member States reveals a mixed picture. While

100 ES the old Member States increased their export share in the new Member States, their share in

80 the intra EU-15 market, as well as in the world

C Z market as a whole, went down. This

60

HU PL development can be explained mainly by the

dynamic export growth of emerging economies,

40

81 83 85 87 89 91 93 95 97 99 01 03 05 07 and of China in particular. In the EU-15 market

between 1999 and 2007, the gain of the new

Source: IMF Member States (+3.1%) does not make up for the

loss of exports from the old Member States (-

Interestingly, the new Member States increased 5.6%). Moreover, the old Member States differ their export market shares in the EU-15 market in respect to the trend in export market shares. Of more strongly before accession while the the largest Member States, the Netherlands dynamic was stronger in the intra EU-12 market managed to increase its export share in the

in the period after the 2004 enlargement, which points to a pattern of regional integration through

trade in Central Europe. Moreover, most of the ( 15 ) However, it should be taken into account that

manufacturing is not the most important sector in Malta.

European Commission

Five years of an enlarged EU

Table III.1.3: Geographical destination of exports of new Member States

% of total 1999 2000 2001 2002 2003 2004 2005 2006 2007 EU-27 81.7 80.6 81.5 80.8 81.1 80.6 79.3 78.9 79.1

OMS 68.6 67.3 67.7 67.3 67.1 65.4 62.5 60.7 59.7 Germany 33.1 31.2 30.4 29.2 29.4 28.0 25.9 25.0 24.3

NMS 13.2 13.3 13.8 13.6 14.1 15.3 16.9 18.3 19.5 Rest of the world 18.3 19.4 18.5 19.2 18.9 19.4 20.7 21.1 20.9

CIS 4.1 4.1 4.4 4.3 4.2 4.8 5.6 6.5 7.2

Russia 1.9 1.9 2.2 2.2 2.0 2.5 3.0 3.4 3.8 China 0.3 0.2 0.3 0.5 0.6 0.6 0.5 0.7 0.7

Japan 0.3 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.3 USA 3.6 3.9 3.4 3.2 3.2 3.1 2.9 2.6 2.1 L. America 0.7 0.6 0.6 0.5 0.5 0.5 0.5 0.5 0.5

Source: Eurostat (COMEXT)

world, Germany maintained a relatively stable 2007. While the share of exports to China more position, but the United Kingdom, France and than doubled to 0.7% in 2007, the share of Italy lost out significantly. This divergence could exports to the US fell by 1.5 percentage points be explained by the stronger ties of some over the reference period. Japan and Latin countries to the dynamic emerging markets, as America remained relatively stable destinations well as by more intensive regionalisation of for new Member States' exports (with shares of

production, e.g. by off-shoring (Danninger and 0.3% and 0.5%, respectively). Joutz, 2007).

Graph III.1.5: Shifts of export destinations from a single old

To sum up, the new Member States gradually Member State, 1999-2007 increased their export market shares in all 1.5

destination groups that were analysed in 1999- % change in e xport NMS O MS RoW

2007, which testifies to their growing 1.0 share competitiveness on the world market. By contrast, the old Member States as a group lost 0.5 export market share, mainly on account of emerging economies. Based on the above 0.0 analysis, it is difficult to draw general conclusions as to how enlargement itself -0.5 influenced export market share dynamics.

-1.0

1.3.2. Export structure by destination -1.5

BE DK DE IE EL ES FR IT LU NL AT PT FI SE UK

An analysis of the geographical patterns of

export and their evolution helps us to understand Source: Eurostat (COMEXT)

the integration process of the new Member States

with the EU and the rest of the world through The geographical structure of the old Member trade, which followed the economic isolation of States' exports remained relatively stable the region before the transition (Table III.1.3). between 1999 and 2007 (Table III.1.4). The Indeed, it was in the 1990s that the most decline in intra-EU-15 exports as a share of the significant shift of the new Member States' total exports of the old Member States was exports towards the old Member States took partially mirrored in the increase in exports to the place. Interestingly, afterwards and particularly new Member States. The old Member States' after the 2004 enlargement, trade within the new exports to the rest of the world as a proportion of Member States intensified. The new Member their total export did not change much between States were also redirecting their exports towards 1999 and 2007 (an increase of only 1.1 emerging economies. Their exports to CIS percentage points). Among the EU's major countries increased noticeably; in particular, trading partners, it is worth noting the growing exports to Russia doubled between 1999 and role of China as a destination of the old Member

Chapter III

Goods and services in an enlarged EU

Table III.1.4: Geographical destination of exports of old Member States

% of total 1999 2000 2001 2002 2003 2004 2005 2006 2007 EU-27 68.0 66.8 66.7 66.9 67.7 67.3 66.6 67.2 66.9

OMS 63.4 62.1 61.7 61.6 62.1 61.5 60.5 60.3 59.5 Germany 13.1 12.7 12.6 12.1 12.2 12.1 11.9 12.0 11.7

NMS 4.7 4.8 5.1 5.4 5.7 5.9 6.2 7.0 7.5 Rest of the world 32.0 33.2 33.3 33.1 32.3 32.7 33.4 32.8 33.1

CIS 1.0 1.1 1.5 1.6 1.8 2.0 2.2 2.5 2.9

Russia 0.7 0.8 1.1 1.2 1.3 1.4 1.6 1.8 2.1 China 0.9 1.0 1.2 1.3 1.6 1.7 1.7 1.9 2.0

Japan 1.7 1.8 1.7 1.6 1.6 1.5 1.4 1.3 1.2 USA 8.7 9.3 9.3 9.3 8.6 8.2 8.2 7.9 7.3 L. America 2.2 2.2 2.2 1.9 1.7 1.7 1.8 1.9 2.0

Source: Eurostat (COMEXT)

States, challenging the position that Japan had Most of the EU Member States increased their occupied since 2004. However, China still lies exports to the rest of the world between 1999 and significantly behind the US as the major, non 2007, which confirms the ongoing process of European destination of the old Member States' integration of these countries into the global exports (with shares of 2.0% and 7.3%, market. On the other hand, exports from Cyprus respectively, for China and the US in 2007). to the rest of the world showed the largest

decrease among the EU Member States.

Graph III.1.6: Shifts of export destinations from a single new

Member State, 1999-2007

1.3.3. Trade balances by geographical

3

% change destination in e xport NMS O MS RoW

2 share The trade balance of the old Member States

1 improved between 2001 and 2003 and

deteriorated after 2004 (Graph III.1.7) following 0 the enlargement, but this was mainly due to

increasing deficits with Russia and the rest of the

-1 world, in particular with China. Among the main

-2 trading partners, there was a trade surplus with

the US and also with the new Member States, -3 which increased slightly after enlargement. On

the other hand, the trade balance between the old

-4

BG CZ EE CY LV LT HU MT PL RO SI SK Member States and China continued to

deteriorate between 1999 and 2007, while the

Source: Eurostat (COMEXT) trade balance of the old Member States with

Japan remained stable during that period. From a single country perspective (Graph III.1.5

or 6), major shifts of export destinations from the With regard to the new Member States (Graph old Member States towards the new Member III.1.8), trade deficits were recorded during the States are most visible in the case of the Baltic period under consideration, a trend which is States, Hungary, Bulgaria and Romania (with consistent with the characteristics of the increases ranging from 0.75 to 2.50 percentage catching-up process, whereby buoyant imports points). At the other extreme, Slovakia's share of support the transformation of the economy. exports to the new Member States between 1999 While the trade deficit of the new Member States and 2007 decreased. The share of exports with the old Member States (excluding directed at the old Member States increased only Germany) halved in 2007 compared to 1999 in the case of Cyprus and Malta, whereas it (Graph III.1.8), the new Member States recorded decreased slightly in all the other Member States, a growing deficit with Germany in the years after and more significantly in the three Baltic the 2004 enlargement.

countries and in Hungary.

European Commission

Five years of an enlarged EU

Graph III.1.7: Trade balance of old Member States in 1999-2007 notwithstanding a seemingly large loss in cost competitiveness. The old Member States, on the

% of GDP

2 other hand, lost market share against a

background of a much smaller deterioration in

US

1 cost competitiveness. As a result, other factors,

NMS such as changes in the product composition of O MS the export basket, are deemed to have determined

0 Russi a the recent trend in export market shares. Several

C IS w/o

Russi a recent papers point to the role of foreign direct

-1 RoW investment in enhancing the growth potential of

C hi na the new Member States (see also section IV.1).

-2 Japan One aspect of the growth potential is the product composition of the export basket.

-3

99 00 01 02 03 04 05 06 07 Before enlargement, it was expected that the new Source: Eurostat (COMEXT) Member States would increase specialisation in

labour-intensive products to take advantage of their lower labour costs. Contrary to

As with the old Member States, net exports from expectations, large flows of FDI, mainly from new Member States improved in bilateral trade old Member States, have led to a significant with the US and turned into a small surplus increase in the technological content and product between 2004 and 2007. quality of the export basket of the new Member

States. The economies of the old Member States

Graph III.1.8: Trade balance of new Member States in 1999-

2007 have taken advantage of enlargement to respond

to the globalisation challenges by off-shoring a

US

1 % of GDP C IS w/o large chunk of their activities to the new Member

Russia States. The qualitative upgrading of production

-1 NMS distinguishes the new Member States from other

O MS w/o

Ge rmany transition economies. This is where EU

-3 Ge rmany accession has made the difference, due to legal certainty, institutional stability and the absence

-5 Russia of trade barriers.

Row

-7 In what follows, we will analyse the quality of

C hi na the export basket of new Member States.

-9 Japan

First, the shares in the export basket of the

-11

99 00 01 02 03 04 05 06 07 different product groups, according to

Source: Eurostat (COMEXT) classifications of products by factor and technology intensity, will be analysed. Attention

Lastly, bilateral trade between the new Member will also be paid to developments in individual States and China is characterised by an new Member States. Second, we will look at increasing deficit, as the new Member States are export market shares of new and old Member also unable to compete with this country on the States in world markets by product group,

basis of its cheap labour and mass production. classified according to factor and technology intensity. Finally, a calculation of unit value

ratios will complement the analysis.

1.4. PRODUCT COMPOSITION

The two previous sections showed that the new Member States increased market shares significantly between 2001 and 2007,

Chapter III

Goods and services in an enlarged EU

Table III.1.5: Breakdown of total exports by factor intensity

Raw-material-intensive Labour-intensive Capital-intensive Research-intensive goods

% of total goods (RMI) goods (LI) goods (CI) Difficult-to-imitate (DIR) Easy-to-imitate (EIR)

1999 2004 2006 1999 2004 2006 1999 2004 2006 1999 2004 2006 1999 2004 2006 BG 26 23 27 31 34 25 25 24 27 13 14 16 5 5 5 CZ 10 8 8 26 20 18 27 27 29 30 30 29 7 15 16 EE 32 21 32 30 32 23 10 12 14 9 13 15 18 21 16 LV 41 35 35 36 32 26 11 18 21 6 9 10 5 6 8 LT 37 45 44 35 25 22 9 10 13 14 15 14 5 6 7 HU 11 10 9 18 12 10 15 13 16 30 32 35 26 33 30 PL 18 16 16 34 25 22 21 25 27 21 26 26 7 7 9 RO 18 16 19 47 41 32 16 18 20 16 20 25 4 5 5 SI 5 4 6 33 27 22 27 29 32 26 29 28 9 11 11 SK 12 12 12 24 19 16 35 39 36 21 21 20 8 9 16 NMS 14 14 14 28 23 20 22 23 25 25 26 26 11 14 15 OMS 12 13 15 19 17 15 22 23 23 29 28 27 19 19 20 World 17 19 22 19 17 15 18 18 18 29 27 27 18 18 18

Note: The factor intensity breakdown is taken from Yilmaz (2002), see Havik and Mc Morrow (2006) for a detailed description. This breakdown splits goods trade into categories which reflect the intensity with which the various production factors are used.

Source: UN Comtrade

1.4.1. Factor and technology intensity of share of labour-intensive goods and the increase exports in capital-intensive goods were broad-based (

16 ).

The upswing in the shares of research-intensive Looking at the breakdown by factor intensity, goods showed some variation across countries. new Member States have adapted over recent The Czech Republic and Slovakia have seen the years the composition of their export basket largest increases for easy-to-imitate researchtowards the composition of the old Member intensive goods, but for these countries (as well States and the world. Specifically, a convergence as for Estonia) this group is still only half as towards these levels has been going on for the important as for Hungary, where it accounts for share of labour-intensive goods, with a large fall 30% of exports. Other countries lag behind, with for the share in the new Member States, from Bulgaria and Romania at the bottom (5%). For 28% in 1999 to 20% in 2006. Similarly, the research-intensive goods, which are difficult to shares of research-intensive goods are imitate, the shares are somewhat more similar converging, in a way which is even more across countries, ranging from 10%-16% in impressive on a somewhat longer time scale: for Bulgaria and the Baltic States, up to 35% for difficult-to-imitate research-intensive goods, the Hungary. Between 1999 and 2006, the largest share went up from 21% in 1995 to 26% in 2006, increase was seen in Romania. while the share of easy-to-imitate researchintensive goods increased from 8% to 15%. Looking at the breakdown by technology

intensity (Table III.1.6), new Member States Finally, in capital-intensive goods, the new significantly reduced their share of low Member States have become even more technology. Notwithstanding this impressive specialised than the old Member States in 2006. decrease, the low-technology share remains This is mainly due to the FDI-induced increased above 30% in Bulgaria, the Baltic States and importance of the automotive sector. Exports of Romania, and stands at 26% in Poland. Mediumthe automotive sector more than tripled between high technology now accounts for a share of 42% 1999 and 2006 and account for 13.5% of total in the new Member States, higher than the world exports of goods of new Member States in 2006

(up from 6% in 1995).

( 16 ) No reference is made to results for Cyprus and Malta.

Regarding developments in the individual new The small size of their manufacturing sector restricts data

Member States (Table III.1.5), the decline in the availability at the product level and reduces the relevance of developments in that sector. Services have a large

weight in their exports (on average over the last four years: 33% in Malta and 83% for Cyprus, against 16% for the new Member States as a whole).

European Commission

Five years of an enlarged EU

Table III.1.6: Breakdown of manufacturing exports by technology intensity

Low-technology Medium-low-technology Medium-high-technology High-technology ICT industries (ICT)

industries (LTI) industries (MLT) industries (MHT) industries (HT) (part of HT)

% of total 1999 2004 2006 1999 2004 2006 1999 2004 2006 1999 2004 2006 1999 2004 2006

BG 44 45 34 29 30 39 25 22 22 2 3 4 1 3 3 CZ 22 19 15 23 21 22 47 46 47 8 14 16 6 14 16 EE 45 45 33 17 16 23 20 22 26 18 17 18 17 17 18 LV 73 68 52 11 15 21 14 15 22 2 2 5 1 2 4 LT 50 45 41 21 22 18 22 25 33 7 8 9 5 6 8 HU 22 19 11 11 11 16 42 41 45 25 29 28 26 29 28 PL 37 32 26 28 27 27 29 35 41 6 6 7 6 7 7 RO 55 54 39 22 18 21 20 22 36 3 5 5 2 6 5 SI 30 26 19 20 20 25 45 48 51 5 6 5 3 4 3 SK 23 25 16 25 21 21 47 49 47 5 5 15 5 5 15 NMS 31 28 21 21 20 22 37 38 42 11 13 14 11 13 14 OMS 22 21 18 17 16 19 43 46 46 18 18 16 13 12 12 World 22 22 17 16 19 37 38 39 24 24 23 19 18 18

Note: The technology breakdown has been developed by the OECD; see Havik and Mc Morrow (2006) for a detailed description of the classification. It groups manufacturing industries according to their skill / technology content. Source: UN Comtrade

average, and not far below the share in the old Looking at the breakdown by factor intensity, Member States. For Latvia, Poland and Romania, new Member States gained market shares of 0.7 this group made the biggest gains between 1999 percentage point up to 1 percentage point for and 2006. each category between 1999 and 2006, except for raw material-intensive goods, for which the gain A very positive development for the new was only 0.2 of a percentage point. The largest Member States is that they have almost caught gain was for capital-intensive goods, specifically up with the old Member States in the area of high between 1999 and 2004. This is also the category technology. Nevertheless, at 14% and 16% for which the new Member States' market share respectively, the shares of new Member States is the largest (1.9% in 2006, against 1.6% for and old Member States still have a large gap in labour-intensive goods and around 1¼% for the relation to the world average (which was 23% in three remaining categories). 2006). Among the new Member States, the largest gains were seen in the Czech Republic The overall loss of market share by the old and Slovakia. Finally, it should be noted that Member States between 1999 and 2006 is the almost all exports of high-technology industries result of three distinct developments by factor from the new Member States are from the ICT intensity group (Graph III.1.10). First, only sector (compared to three quarters for the old capital-intensive goods gained market share. As Member States and the world). This may suggest a result, the EU-27 market share for capitalthat some other, potentially valuable, highintensive goods gained an impressive 1.8 technology industries are absent in the new percentage points and its market share level (at Member States. 25.3% in 2006) significantly exceeds the overall EU-27 share. Second, old Member States lost out

1.4.2. Export market shares according to in raw material-intensive goods and labourfactor

and technology intensity intensive goods. These are logical losses in

sectors where old Member States have no The shift in the composition of the export basket comparative advantage. of the new Member States towards more technologically advanced and research-intensive Thirdly, losses for the old Member States were goods was larger than the corresponding shift in also noted for both categories of researchthe export basket of the world. As a result, the intensive goods. The loss for easy-to-imitate export market shares of the new Member States research-intensive goods was very large (2.7 for such goods should have increased (Graph percentage points), but half of the loss occurred III.1.9). in the final year of the sample (2006), for which

data are probably not yet fully stable. It remains

Chapter III

Goods and services in an enlarged EU

to be seen whether further releases for 2006 and, Graph III.1.10: Old Member States: export market share by

eventually 2007, will confirm the extent of the factor intensity loss. While the loss for difficult-to-imitate 29 % of worl d e xport marke ts (e xcl . EU) 14

research-intensive goods was only 0.9 of a

percentage point between 1999 and 2006, the 28 DIR

trend in its market share over a longer period is 27 12 more worrying: it decreased from 27.6% in 1995 26 RMI (rhs)

to 24.3% in 2006. 25

10 24

Graph III.1.9: New Member States: export market share by

factor intensity 23

C I EIR

2.0 8

% of worl d e xport marke ts (e xcl . EU) 22

1.8 LI 21

C I

1.6 LI 20 6

95 96 97 98 99 00 01 02 03 04 05 06

1.4 Note: Abbreviations: see Table III.1.5

Source: UN Comtrade 1.2

RMI

1.0 The old Member States have been losing market

0.8 share for all product groups (Graph III.1.12),

DIR

EIR except for medium-high technology, in which 0.6 they had built up a very strong position with a 0.4 market share of 29.8% in 2006. At first sight, the

95 96 97 98 99 00 01 02 03 04 05 06 size of the loss for high-technology goods (3.1 Note: Abbreviations: see Table III.1.5 percentage points) is very worrying. However, Source: UN Comtrade for easy-to-imitate research-intensive goods

(Graph III.1.9) almost half of the loss occurred in At the EU-27 level, the gains of the new Member the last year of the sample, for which the data States between 1999 and 2006 do not make up may not yet be stable. for the losses of the old Member States, although capital goods are an exception (see above). Graph III.1.11: New Member States: export market share by

Specifically the loss for difficult-to-imitate technology intensity research-intensive goods, although small (0.3 % of worl d e xport marke ts (e xcl . EU)

percentage point), does give cause for concern. 2.0

Moreover, as for the old Member States, the loss MLT for this sector has been sizeable since 1995 LTI

(down from 28.2% to 25.6% in 2006). 1.5

Looking at the breakdown by technology 1.0 intensity (Graph III.1.11), between 1999 and MHT HT

2006, the new Member States gained market shares of 0.8 and 1 percentage point for the two 0.5

"medium" categories, against 0.5 of a percentage

point for the remaining categories. While this IC T seems to be a modest increase for the key high 0.0 95 96 97 98 99 00 01 02 03 04 05 06

technology industries, it denotes a slight

acceleration of the build-up in market share. Note: Abbreviations: see Table III.1.6 Source: UN Comtrade

From a very low level of 0.2% in 1995, the share rose to 0.4% in 1999 and to 0.9% in 2006. The

market share of new Member States for the other Nevertheless, the market share for highproduct categories is significantly higher technology goods is only about half of the share

(ranging from 1.5% to 1.9% in 2006). of medium-high technology goods. Again at the EU-27 level, the gains of the new Member States

European Commission

Five years of an enlarged EU

do not make up for the losses of old Member product if they perceive it to be of better quality States, only this time it is medium-high (Fabrizio, Igan and Mody, 2007). technology goods that are the exception. The unit value index of a traded product is For every product group, in both breakdowns, defined as the value of the product divided by its the evolution of the market share between 2004 physical weight. Unit value indices have to be and 2006 was much more unfavourable than analysed with the greatest possible caution. For between 1999 and 2004. example, if the analysis is not conducted at the most detailed product level, the unit value index In some cases, a gain was even turned into a loss will reflect the composition of the product group. during this much shorter period. It is clear that Technological progress and exchange rate competitiveness losses, mainly due to exchange developments are two of the many factors which rate developments, have played a large role. As a could influence the development of unit value result, it is not straightforward to determine to indices over time. which extent the EU's loss of market share is due to the emergence of new competitors, or to price One way of getting around most of the possible and non-price competitiveness developments. problems with unit value indices is by using the unit value ratios, which are obtained by dividing Graph III.1.12: Old Member States: export market share by the unit value index for an individual product for

technology intensity a specific country by the corresponding unit 35 value index for the world as a whole ( 18 ). Over

% of worl d e xport marke ts (e xcl . EU) the sample, only products for which observations

30 for unit value indices are available for each year MHT for the specific country and the world are taken

into account ( 19 ). The weighted average of the

25 MLT individual unit value index ratios over all

products results in a unit value ratio per country. 20 LTI

HT Between 1999 and 2006, unit value ratios went 15 IC T up in all new Member States and in 2006 even

exceeded 1 for Latvia, Poland and Slovakia. The unit value ratios of the new Member States are

10

95 96 97 98 99 00 01 02 03 04 05 06 still lower than the result for the group of old

Member States (1.17 in 2006), but the gap is

Note: Abbreviations: see Table III.1.6

Source: UN Comtrade narrowing with time. Between 1999 and 2006,

the median unit value ratio increase for the new Member States was 0.16 against 0.09 for the

1.4.3. Unit value indices average of the old Member States. The fastest

Up to now, the product composition of the export increases were observed (in that order) for baskets has been analysed on the basis of specific Hungary, Poland, Latvia, the Czech Republic groups of products. An alternative way to look at and Romania (all were faster than the median). the content of an export basket is to analyse its On the other hand, the increment in Bulgaria and

average price, as estimated by unit value indices. Estonia was smaller than for the old Member States' average. These two countries have also

The unit value index of an export basket should the lowest unit value ratio in 2006.

be a proxy for its quality, on the assumption that

a higher price reflects higher quality ( 17 ). This

assumption is based on the idea that consumers ( 18 ) In this analysis, calculations were done at a very detailed would be willing to pay more for the same product level: manufactured products in the SITC

classification at 5 digits were taken, implying the potential use of 2678 products.

( 19 ) Products are also excluded (for a specific country or the ( 17 ) Recently this assumption has become more controversial, world) if their unit value index shows a volatile

see for example Hallak and Schott (2008). development.

Chapter III

Goods and services in an enlarged EU

Table III.1.7: Export quality as measured by unit value ratios

World = 1 change between 1999 and 2006 level 2006

BG 0.05 0.82 CZ 0.19 0.94

EE 0.05 0.86 LV 0.22 1.00

LT 0.11 0.89 HU 0.28 0.89

PL 0.25 1.07 RO 0.17 0.91

SI 0.10 0.93 SK 0.16 1.01

OMS 0.09 1.17

Note: Methodology as in Fabrizio et al. (2007)

Source: UN Comtrade

The analysis of unit value ratios is a useful complement to the analysis of the product composition of the export baskets by referring to specific groups of products. It also leads to the conclusion that the quality of the export baskets of the new Member States improved between

1999 and 2006. On the other hand, progress in individual new Member States is ranked somewhat differently using this calculation. One possible explanation for this difference is the reduced relevance of observed unit values due to the increased importance of intra-firm trade (see also Eden, 2001).

• 2. 

  THE FUNCTIONING OF THE PRODUCT MARKETS IN THE

  RECENTLY ACCEDED MEMBER STATES

While the previous section in the chapter focused considered to have the highest potential for on the international dimension of the future growth and wealth creation. In nine of the liberalisation of goods, and examined the drivers, new Member States the share of people composition and effects of foreign trade, this employed in high-tech manufacturing and section assesses how the functioning of markets knowledge-intensive high-technology services has evolved in the new Member States. First, it has increased in recent years (Graph III.2.1). documents the shift to a knowledge society in order to set the scene for an analysis of Graph III.2.1: Employment in high-tech manufacturing and

competition from various angles. A section is knowledge-intensive high-technology services

devoted to the overall evolution of competition RO % of total e mployme nt followed by one on governance and regulatory C Y

policies. Lastly, competition in specific sectors LV PL

is examined, including telecommunication, LT 2004 - 2006

energy, retail, postal and professional services. NMS 1999 - 2003

BG

SI

2.1. SHIFT TOWARDS A KNOWLEDGE EE

SOCIETY SK

C Z

O MS

The 12 new Member States still rely too a great HU extent on agriculture and traditional manufactu MT

ring, but the available indicators, which are 0 1 2 3 4 5 6 7

presented in this section, clearly point to a

structural shift towards services and the Source: Eurostat

knowledge intensive economy, where resources

such as know-how, expertise and intellectual Furthermore, the share of high-tech exports has property are driving factors of value added. increased slightly in several new Member States. These indicators also reveal that, on average, in Estonia and Hungary had already a high share of terms of knowledge intensity the new Member high-tech exports in the pre-accession period, States are still lagging behind the old Member while the Czech Republic and Slovakia made an States and several emerging markets outside the impressive post-accession jump (Graph III.2.2).

EU.

Graph III.2.2: Exports of high technology products

Moreover, the widespread dissemination of BG % of total e xports 2006

Information and Communication Technology C Z 1999

(ICT) has brought profound changes to the new EE

Member States. Over the years the cost of LV information has fallen and the most valuable LT asset is investment in intangible, human and HU

social capital. ICT has triggered various types of PL RO

innovations and has changed the way of working SI

and living. SK

NMS

2.1.1. High-tech manufacturing and O MS knowledge-intensive high-technology WO RLD

services 0 5 10 15 20 25 30

The high-tech manufacturing and knowledge Source: Table III.1.6 in Chapter III.1

intensive sectors use or develop the most advanced technology or methods, so they are

Chapter III

Goods and services in an enlarged EU

2.1.2. Capacity to innovate increases between 1999-2003 and 2004-2005.

Bulgaria and Slovenia have recorded the biggest

The European Innovation Scoreboard is the most percentage increase since 1999.

comprehensive output indicator, which

characterises the shift towards a knowledge Graph III.2.4: European Patent Office applications

based economy. There is a clear upward trend in

the capacity to innovate in the 12 new Member RO LT

States, whereas the innovation performance of BG Numbe r pe r mi l li on i nhabitants

most old Member States is either stagnating or PL declining (Graph III.2.3). SK

NMS

Graph III.2.3: The European Innovation Scoreboard EE

LV

RO C Y LV C Z

BG HU 2004 - 2005

PL 2007 MT 1999 - 2003

SK 2003 SI

HU O MS

LT 0 50 100 150

MT

Source: Eurostat

C Y

SI

C Z 2.1.4. R&D expenditure

EE

EU-27 Research and development (R&D) activities

0.0 0.1 0.2 0.3 0.4 0.5 consist of creative work undertaken on a

systematic basis in order to increase the stock of

Source: European Innovation Scoreboards knowledge and the use of this stock of

knowledge to devise new applications. R&D

Unsurprisingly, most new Member States are intensity represents R&D expenditure as a characterised as ‘catching-up countries’ percentage of GDP.

(Bulgaria, Hungary, Latvia, Lithuania, Malta,

Poland, Romania and Slovakia) but other have The R&D intensity in the 12 new Member States evolved into moderate innovators (Cyprus, is far below the EU average (see Chapter VII.1). Czech Republic, Estonia, Slovenia). There is a It is also lagging behind a number of emerging general process of convergence, and innovation markets outside the EU which have further followers are closing the gap on innovation increased their lead since 2004 (notably Southleaders. The Czech Republic, Estonia and Korea, Singapore and Russia). However, Lithuania could reach the EU innovation average significant increases can be observed for Estonia, within 10 years. Malta, Czech Republic, Lithuania and Latvia.

2.1.3. Patent applications 2.1.5. Skills

For all new Member States, except Cyprus and One of the reasons why skills and lifelong

Estonia, the number of patent applications to the education have become so important is the

European Patent Office is growing, but is still acceleration of scientific and technological well below the average of the old Member States progress. Despite the increased duration of (Graph III.2.4). The countries with the highest primary, secondary and university education, the increase in applications are Slovenia and Malta. knowledge and skills acquired there are usually

not sufficient for a professional career. As regards the number of patents granted by the

United States Patent and Trademark Office, the Cyprus channels nearly 7% of its GDP into data for the new Member States (in terms of public investment in education - one of the

patents per million inhabitants) show significant

European Commission

Five years of an enlarged EU

highest levels in the EU. Bulgaria, the Czech 2.2. OVERALL EVOLUTION OF COMPETITION Republic and Romania are catching up in the areas of public investment in education and Perceptions among the business community training, while private investment in education is suggest that competition in the new Member significant only in Cyprus and Slovakia. States is increasing significantly and the widened business advantages provided by the EU Single In Malta almost all pre-school children (4 years Market play an important role in the expansion old) receive education. Slovenia (+11%) and of business activities in the new Member States: Romania (+15%) have achieved significant increases in this area since 2000. (1) A representative pan-European survey (Observatory of European SMEs, 2007) shows The new Member States are among the best perthat 67% of enterprises in the new Member forming countries in the EU in terms of their States report increased competition within their upper secondary attainment: the Czech Republic, markets while only 7 % of them believe that it Poland, Slovenia and Slovakia are above 90%; decreased during the last two years (Graph Lithuania and Cyprus are above 85% and Malta III.2.6). In the old Member States, competition (+14%) has made significant progress (from a seems to have increased somewhat less: 58% of low base). their enterprises report increased competition and 5 % report that it has decreased during the last Graph III.2.5: Tertiary graduates in science and technology two years. According to the perceptions recorded MT in the survey, competition has intensified in all C Y Numbe r pe r 1000 of popul ation age d 20-29 new Member States more than on average in the HU old Member States, which indicates that the new C Z Member States have overall well functioning

BG markets and that increased competition is

NMS

SI underpinning the catching-up process at the

LV macro-economic level.

SK

RO 2004 - 2005 (2) According to the same survey, the features of

PL 1999 - 2003 the Single Market of the EU are highly important

EE for the business activities of enterprises located

O MS in the new Member States, even though a

LT comparatively large number of their enterprises

0 5 10 15 20 do not appear to operate in foreign EU markets

Source: Eurostat (2008f) (about 40% compared to one third of enterprises in the old Member States). A relatively high

All new Member States display are achieving share of enterprises in the 12 new Member States increasing shares of tertiary graduates in science attributes significant importance to the Single and technology. Romania and Lithuania had the Market legislation (46% as compared to 37% in highest increase (Graph III.2.5). The only data the old Member States). This indicates that the that can be compared worldwide are the number enterprises in the new Member States are of researchers per million inhabitants, where old relatively well integrated in the EU. The same and new Member States have increased their currency in most of the EU Member States and respective figures. However, the new Member the absence of border controls are the second and States (on average 1.574 researchers per million third most important Single Market features for

inhabitants in 2004-2006 according to Eurostat) enterprises in the new Member States. still lag behind the old Member States (2.905 researchers per million inhabitants) and Within the new Member States the increase in competitors such as South Korea and Hongquality, which within the entire EU is the most Kong (3.732 and 2.090). frequently mentioned strategy to deal with increasing competition, is a particularly popular response in Estonia (86%), Slovakia (81%), Romania (79%), and Bulgaria (78%). It is the

Chapter III

Goods and services in an enlarged EU

Graph III.2.6: Perceived development of competition

Incre ase d Re mai ne d about the same De cre ase d Don't know/not avail abl e

100% 4 2 1

1 6 2 6

2

3 2 1 1 2 6 5 7 4 5 2 2 1 3 3 3 5 2 4 5 2 2 6 5 5 4 8 5 5 6 4

90% 9 5

7 7 6 7 6 7 7 5 8 10 5 5 5 5 5 7 15 14

11 23 14 7

7 8

80% 17 23 23 25 25 24 4

5

22 23 25 26 26 30 25 26 27 34 23

70% 19 29 30 31 33 27 32

35

28 36 38

60% 38

50%

40% 85 81 73 72 72 69 69 68 67 67 67 67 66 66

30% 65 65 65 64 63 63 62 61 60 60 59 58 58

54 53 51 50 20% 44

10%

0% T

M E

L

S K O G

I T 0 E 7

R B S

I F

P L S M C Y A C Z L

T IT IE P T E D U H E E

S

L U E A V L S S E B E D K U K F

R

N E U

-1

E U

-2 L N M

O

Note: Based on all enterprises surveyed (17283), including large enterprises. Question: Has competition within the markets of your enterprise altogether decreased or increased during the last two years?

Source: Eurobarometer

most important strategy in the Czech Republic, their situation: France, Belgium, Italy, Hungary

Estonia, Hungary, Slovakia and Bulgaria. and Malta.

The survey also enquired about the state of play Graph III.2.7: Incidence and change of business constraints and development of nine potential constraints 40 Rece nt chan ge (ave rage )

that enterprises, especially small and medium EL SI 30 S K SE sized enterprises (SMEs), typically have to face, PL PT RO

20 LT including limited access to finance and problems

CZ LV UK FI

with administrative regulations (Graph III.2.6). 10 IE DK BG

DE ES 0 EE AT NL

The upper right section in Graph III.2.6 is the C Y -10 EU 27

most advantageous one, where SMEs face only a -20 HU

few obstacles and most of those who do face IT -30 obstacles consider, on balance, that their MT LU situation is either unchanged or improving. -40

BE

Especially Nordic countries are in this situation, -50 FR In cide n ce (ave rage )

but also Bulgaria, Estonia and Latvia. The upper -60

left square includes those countries whose SMEs 40 35 30 25 20 15 10

are constrained more than the EU average, but Note: Based on SMEs only (16339 of the total of 17283 enterprises).

whose situation is unchanged overall or even There are nine constraints covered: limited access to finance, costs of labour force, lack of skilled labour, implementation of new

improving. The countries belonging to this group technology, implementation of new forms of organisation, lack of

are predominantly the new Member States quality management, administrative regulations, problems with infrastructure, problems with the purchasing power of customers.

(Czech Republic, Slovakia, Slovenia, Lithuania, Source: Eurobarometer

Poland, and Romania). The bottom right area includes those economies where a relatively low Hence the overall picture is encouraging, since proportion of SMEs face one of the typical for 9 out of the 12 new Member States the difficulties investigated, but they dominantly perception on business constraints seems to have report a worsening situation (Luxembourg and – improved. However, SMEs in most of the new marginally – Cyprus). Finally, the most Member States are more conscious of constraints disadvantageous location on this map is the on their business activities than in the old EU bottom left square with countries whose SMEs Member States. This applies for instance on are not just troubled by the various constraints, business constraints due to limited access to but have experienced a further deterioration in finance, with 25% of the SMEs of the new

member States reporting constraints in this area

European Commission

Five years of an enlarged EU

as compared to 21% of the SMEs in the old EU (Council of the European Communities, Member States. The situation in the area of 2003). infrastructure is similar. Many more enterprises in the new Member States than in the old Each new Member State has set up a national Member States perceive this area as constraining competition authority responsible for enforcing their business activities, but the effort to reduce national competition law as well as the EU these constraints is – not least due to the competition rules. Despite significant efforts and contribution of the EU cohesion policy - general progress, the enforcement of competition significantly greater in the new than in the old law remains a challenge in some of the new Member State. Member States. A few Member States are still in the process of adapting their national legal A closer examination of the birth and survival framework to enhance effective enforcement. In rates of enterprises does not show any clear addition, some of the authorities face budgetary trends until 2005 (the latest year for which data constraints and/or have to cope with significant on business demography are available in fluctuation of staff, which in most cases are not Eurostat). Birth rates increased between 2002 easy to resolve. and 2005 in four Member States (Bulgaria, Cyprus, Slovenia and Romania), indicating the As from 1 May 2004, the Commission and the existence of an environment which is favourable national competition authorities have formed a to competition. However, in six Member States cooperation network entitled the European (Czech Republic, Estonia, Hungary, Lithuania, Competition Network. Its main purpose is to Latvia and Slovakia) the numbers have remained secure the efficient and coherent application of unchanged or have decreased during this period EU competition rules by the Commission and the (for Malta and Poland no data are available). competition authorities in the various Member States. For this purpose, the European Competition Network relies on legal tools in the 2.3. GENERAL GOVERNANCE OF relevant regulation that provides for the COMPETITION AND REGULATORY possibility to exchange case-related information POLICIES and to give assistance with investigations to other authorities. It also lays down information The Europe Agreements, which were signed obligations aimed at effective work sharing and between the EU and the twelve countries which coherent decision-making in the application of joined on 1 May 2004 and 1 January 2007, the EU Treaty competition rules. The European contain competition rules equivalent to those Competition Network has furthermore become found in the Treaty. Furthermore, the accession an important framework for voluntary and process required that these countries implement informal cooperation between the authorities EU competition rules in their domestic law. concerned. Hence, the competition law regimes have been developed on a permanent basis. The reform of Leniency programmes are important crossthe

implementing EU regulations entailed further sectoral tools to uncover cartels ( 20 ). The network

changes in national competition legislation. members have elaborated a Model Leniency Consequently, in the past five years the new EU Programme, with the aim of removing the most Member States have either enacted new damaging discrepancies between the different competition laws or amended their existing European programmes and to facilitate multiple competition acts in order to increase the powers leniency filings in Europe. Whilst the Model of their national competition authorities. These Programme is not a legally binding document laws have now extensively converged with the and does not prevent members from adopting a

EU competition rules. Importantly, the provisions of the new regulation on the enforcement of the European competition rules ( 20 ) The leniency program applied by the European

laid down in Articles 81 and 82 of the Treaty, Commission is currently set forth in the Notice on

has been implemented in all new Member States Immunity from Fines and Reduction of Fines in Cartel Cases (the “Leniency Notice”), Official Journal of the

with effect from their dates of accession to the European Union, C 298, 8.12.2006, p. 17.

Chapter III

Goods and services in an enlarged EU

Table III.2.1: Total state aid

2000-2003 2004 2005 2006 OMS EU-10 OMS EU-10 OMS EU-10 OMS EU-10 Total aid, million € 34000 5654 56400 5200 58700 5100 44000 3200

% of GDP 0.4 1.4 0.4 0.7 0.4 0.5 0.4 0.5

Note: Total aid less agriculture, fisheries and transport

Source: European Commission (2007d)

more favourable approach towards applicants, simultaneously endorsed the Lisbon objectives to the ECN members have undertaken to use their reduce and redirect State aids towards horizontal endeavours to align their respective programmes objectives including cohesion. with it. The Model Programme also introduces a summary application system that facilitates the How have these objectives been pursued procedure when an applicant wants to protect its throughout the period from the date of position with one or more national competition accession? authorities in addition to the Commission. This will save resources for both applicants and 1) A clear reduction of the level of State aid in authorities. Today, all the Member States, the new Member States can be noted between except for Slovenia and Malta, have leniency 2004 and the year with the latest available data programmes, whereas in 2002 only four Member (2006), in absolute terms and as a percentage of States operated such programmes. Slovenia and GDP (Table III.2.1). The sharpest falls in the Malta are also in the process of developing such new Member States can be observed in the programmes and are expected to adopt them Czech Republic, Cyprus and Malta, largely soon. owing to the phasing out of pre accession

measures, and in Poland due to the declining aid to the coal industry, (European Commission ,

2.4. STATE AID 2007d). In some other Member States the decrease is smaller due to some sector

Before accession, candidate countries had “to specificities (aid to steel in Slovakia, for demonstrate the existence of a functioning example). The reduction trend in the new market economy as well as the capacity to cope Member States (as well as in EU as a whole) is a with competitive pressure and market forces sign that these countries have continued their within the Union”. From the beginning, State aid efforts after accession to adjust their state aid control had been understood in the enlargement policies and practices to the EU requirements in process as contributing to a properly functioning that field. This is particularly noteworthy as these economy. Future Member States were requested countries had to face huge structural changes. in the pre-accession period to put in place a The introduction of new principles and proper legislative framework and develop an institutions in managing projects through the EU adequate administrative capacity to control State regional policy contributed to this aspect. aid measures, through State aid monitoring authorities. The idea was to ensure that the 2) At 0.5% of GDP in 2006, State aid in the new candidate countries would be ready to implement Member States nevertheless remains higher than Community State aid rules at the time of in the old Member States. Among the new accession, by slowly getting companies and Member States it ranges from 0.08% in Estonia public authorities accustomed to a similar State to 1.77% in Malta. These significant variations aids discipline. reflect the singularity of each country, its

industrial and economic structure and its The candidate countries accepted that approach priorities, but they are also influenced by a and underwent a strict screening of their State aid relatively small number of cases. measures before the accession phase. In May

2004, they were ready to apply State aid rules for 3) All new Member States are successfully the future, having ensured that some existing aid redirecting their State aid policies towards would benefit from a transition mechanism. They horizontal objectives, including cohesion (Table

European Commission

Five years of an enlarged EU

III.2.2). Horizontal objectives cover aid for Member States must establish independent environment and energy saving, SMEs, national regulatory authorities responsible for the employment, regional development, R&D, implementation of regulations within the training and other horizontal objectives such as country's territory. The main tasks of these culture. By contrast, sectoral aid covers authorities, as defined by the relevant shipbuilding, coal, steel, restructuring aid and Commission Directive (Council of the European other non-manufacturing or services-related aids. Communities, 2002), are consumer protection This illustrates the efficiency of the and the establishment of an innovative, implementation of State aid by the monitoring competitive, and sustainable telecommunication authorities which has contributed to the goal of industry. The new Member States had to adapt making public authorities and companies their corresponding regulations and authorities to accustomed to the requirements of EU State aid the existing regulatory telecommunications laws and practices. It also expresses the efforts of package of the EU to meet the accession the new Member States to contribute from the obligations. Additionally, they have had to outset to commonly decided objectives. accommodate changes in the European regulatory framework which took place after the Table III.2.2: State aid: sectoral and horizontal objectives accessions. The revision launched in 2007 seeks

2002-2004 2006 to bring the framework up to date for the fast%

of total Sectoral Horizontal Sectoral Horizontal developing telecommunication sector in an objectives objectives objectives objectives.

enlarged Union.

EU-10 77 23 22 78 EU-25 32 68 15 85

Note: Total aid less agriculture, fisheries and transport Application of the regulatory package

Source: Euroepan Commission (2007d)

Due to the adoption the EU acquis, the telecommunication markets in the new Member

2.5. COMPETITION IN SPECIFIC SECTORS States are now liberalised. In this context,

independent regulatory offices have been created in the two youngest Member States.

2.5.1. Telecommunication sector

The telecommunication sector is very important Market opening has effectively led to more for growth, competitiveness and employment. In competition in terms of the number of the four years up to 2008, the value of all competitors. While in some countries (such as in telecommunication markets of the 12 new Bulgaria) the market shares of the incumbent still Member States had increased by 38% to an remains very high, alternative operators in other estimated € 26.4 billion. In comparison, growth new Member States already have significant in the old Member States was much slower: only market shares, in terms of both infrastructure and 6% over the same period. Although admittedly mobile phone competition (European starting from a relatively low base, the telecom Commission, 2007b). In the Czech Republic, for munications market of the new Member States instance, 66% of wireless infrastructure-based has been one of the main drivers of growth in the competition in 2006 already involved new overall EU market, driven by mobile services entrants. According to the most recent figures, and, to a lesser extent, by broadband services. the biggest decline of an incumbent's market

share in the fixed telephone market of the EU

Regulatory context was seen in the Czech Republic (from 72% in

2005 to 64% in 2006). Recent figures on

The European Commission is responsible for Slovenia are also promising, since in all providing a common European regulatory Slovenian telecommunication markets (fixed, framework for the telecommunication industry internet, mobile) there were important new

and for monitoring its implementation ( 21 ). All

( 21 ) This framework is explained in detail at the following http://ec.europa.eu/information_society/policy/ecomm/cu

website: rrent/index_en.htm .

Chapter III

Goods and services in an enlarged EU

entries in 2007 and 2008; it is therefore likely fixed incumbents of eight countries. Competition that the incumbent's share will decrease further. has gradually started to develop in those

countries. Importantly, the EU telecommunication markets, including those of the new Member States, have The competitive landscape has changed in the exhibited increasing volumes and falling prices last five years, and as of June 2007, the market

over the last few years ( 22 ). had been completely liberalised in all the new

Member States, where more than 450 operators The full implementation and enforcement of the (as compared to 100 in 2002) are offering public telecommunication framework is expected to voice telephony, i.e. an average of 38 operators boost competition and push prices further down. per country, at both national and local level In fact, several National Reform Programmes, (European Commission, 2007b). However, as it like that of the Czech Republic, emphasise the happened in the old Member States, many new need for a continuing liberalisation and entrants concentrate their business at the outset strengthening of competition in the electronic on specific segments of the market or limit their communication market (National Reform activities to local areas, thus having a limited Programmes, 2008). Cyprus is a good example impact on the national market as a whole. of how the continuous implementation of the

framework is bearing fruit ( 23 ). Lithuania is Mobile market

another example where the enforcement of EU law by the national regulatory authority is The strong dynamism in the mobile phone

leading to more competition ( 24 ). market reflects the high level of competition in

this sector: The growth of the mobile market in Given the significant technical differences across the new Member States countries took of the telecommunication markets, each segment between 2002 and 2007, and at the end of 2007 needs to be viewed separately. some of these countries are amongst the

countries with the highest mobile penetration Fixed telephony rates in the EU (European Commission, 2007g,

pages 7-17).

The fixed telephony market was not open to competition on 1 May 2004 in the majority of the On average, the mobile penetration rate of the new Member States, where only the national twelve new Member States amounted to 105%

incumbent was authorised to provide services. ( 25 ) in 2007 - only 7 percentage points below the

The State still held a controlling stake in the EU average rate. In two thirds of the new

Member States, each inhabitant has on average more than one mobile subscription (only Malta, Poland, Romania and Slovenia have penetration

( 22 ) Concrete figures are published in the annual

implementation reports of the EU framework, which are rates below 100%). With penetration rates of

accessible a the following website: 144% and 140% respectively, Lithuania and

http://ec.europa.eu/information_society/policy/ecomm/li Latvia are among the top three performers in the

brary/communications_reports/index_en.htm whole of the EU. The relatively strong

( 23 ) The sectoral regulator completed in 2006 the audit of the

incumbent’s costing system to determine the cost of competition in the new Member States is

retail and wholesale services; the results of this audit underlined by the fact that small economies like have been used in the review of the incumbent’s Latvia and Lithuania have the same number of

reference Interconnection Offer and the Retail Price

Control Measures imposed on the incumbent. In the mobile network operators (3) as the French

previous year, the incumbent was fined with a significant economy; Estonia has the same number of

amount for abusive conduct in the mobile telephony operators (4) as Germany, Italy and Spain.

market by the Cyprus Commission for the Protection of Competition.

( 24 ) Concretely, the national regulation authority requested

the incumbent to apply non-discriminatory technical

investigation deadlines, not to charge a technical ( 25 ) The mobile penetration rate is defined as the number of

investigation fee, and to give access to the network mobile telephone active cards per 100 inhabitants. This information system free of charge. rate can exceed 100% as consumers may have more than one card.

European Commission

Five years of an enlarged EU

Number portability, which enables mobile States (91% national coverage, 96% urban subscribers to keep their number when they coverage, 72% rural coverage) and new Member move from one operator to another, is considered States (69% national coverage, 62% urban, 42% as a key measure for promoting competition rural). Significant investments to upgrade the within the telecommunication sector. Thus, networks have been made in the past few years under the terms of an EU-Directive which took and at the end of 2007 many new Member States effect in July 2003, all EU Member States are enjoyed coverage rates similar to many of the old required to introduce number portability. It is Member States. At the end of 2007 national encouraging that all new Member States – except coverage in the new Member States was 79% on Bulgaria and Romania – had implemented this average, i.e. 88% in urban areas and 64% in rural

competition factor by the autumn of 2007. areas.

Also regarding the deployment of the new 2.5.2. Energy sector

generation mobile telephony (so-called G3 phones), offering enhanced services such as Properly functioning energy markets that ensure video calls and mobile internet, competition is secure energy supplies at competitive prices are improving in the new Member States, given that key to achieving growth and consumer welfare in the latter are increasingly granting the relevant the European Union. To attain this objective the

licences ( 26 ). EU decided to open up Europe’s gas and

electricity markets to competition and to create a Broadband market single European energy market. The process of

market opening has significantly changed the There were significant differences in the functioning of the markets, provided new market broadband market at the time of the 2004 opportunities and led to the introduction of new accession. Whereas in 2004 the market share of products and services (European Commission, the incumbent operator in the total national 2006d). telecommunication market amounted to around

30% in Malta or Lithuania (EU average: 56%), Almost all new EU Members States have the incumbent in Cyprus in the same year formally opened their national energy markets. controlled 100% of the broadband market and in From a legal viewpoint, the consumers from Poland and Latvia as much as 94% and 81% these countries are now able to choose their respectively. Competition is highly dependent on supplier and benefit from competition. In the the availability of alternative networks. case of some new Member States to which Specifically in the DSL market, where derogations have been granted within their broadband access is provided through the accession treaties, this liberalisation process is existing telephone network, incumbents in many foreseen to be concluded by 2013 (Malta, new Member States still dominate the market. Cyprus, Slovenia, Czech Republic) (European

Nonetheless, growth in the broadband market has Commission, 2007g). constantly remained high in recent years. Notwithstanding, problems such as high market A crucial condition to enable competition of concentration and vertical integration of energy broadband services is the availability of production, infrastructure and distribution remain corresponding infrastructure. At the end of 2005, a problem in the old as well as the new Member 87% of the EU territory was covered by DSL, States. To remedy this situation, the legislative i.e., a technology that enables the provision of proposal of the European Commission of data transmission over the wires of the traditional September 2007 on electricity and gas markets telephone network. However, this figure hides requires the effective unbundling of transmission large disparities between urban (93%) and rural system operators and supply and production (66%) areas, as well as between old Member activities not only at national level but throughout the EU (European Commission, 2007g). It means in particular that no supply or

( 26 ) Malta, for instance, has awarded since 2007 three production company active anywhere in the EU

respective concessions. can own or operate a transmission system in any

Chapter III

Goods and services in an enlarged EU

Member State of the EU. This requirement can be observed across all the new Member applies to EU and non-EU companies alike. The States, especially in relation to electrical goods, purpose of this proposal is to ensure that all which indicates strong competition. The entry of European citizens can take advantage of the large international retailers in both specialised numerous benefits provided by a truly and non-specialised sectors has intensified the competitive energy market. It illustrates that, in competition for domestic players in these areas. the energy markets too, EU membership might A further strengthening of competition is likely further strengthen competition in the new to come from supermarkets, which are now Member States. competing in most of the sub-markets included

in this sector (e.g. clothing, furniture, electrical

2.5.3. Retail goods).

Since accession to the EU the retail sector has 2.5.4. Postal services

developed rapidly in all new Member States, generally due to investment made by major Regulatory framework

Western European retailers (London Economics and RPA, 2008). Rapidly developing modern Postal services in the EU are covered by the retail formats, increased interest on the part of Postal Directive (Directive 97/67/EC i as amended pan-European retail companies and rising living by Directive 2002/39/EC i and Directive standards are among the main factors which have 2008/6/EC). It constitutes a regulatory contributed to a high level of dynamism and framework which guarantees citizens a high significant consolidation of retail markets in quality universal service at least five times a these countries (European Retailing 2010, 1998). week, on the whole territory, at an affordable Moreover, the supermarket networks have price, while gradually limiting the scope of the

expanded quickly in recent times because they reserved area ( 27 ). As required by the Directive,

have are perceived by the consumers from these the Commission had confirmed by the end of countries as offering an increased choice and low 2006 the target of full market opening by means prices. of a further amending Directive. This amending

Directive (the third Postal Directive – Directive At present, the high concentration rate is tending 2008/6/EC) was adopted, by the Council and the to become one of the main characteristics of European Parliament, on 20 February 2008. It retail markets (e.g. food retail chains), especially provides for the full liberalization and in small Member States like Slovenia and Latvia. establishment of the internal postal market by Following the accession negotiations, the abolishing any remaining exclusive rights by 31 national anti-monopoly legislation was December 2010. In particular, the Commission harmonized with EC competition rules. In some will pay close attention to potential entry barriers new Member States such as Lithuania, Romania that might deprive users of the benefit of a and Hungary, producers and retailers have signed dynamic and open market. Some Member States so-called codes of conduct (e.g. "Code of Fair have been granted the possibility to postpone full Conduct", "Guide of Good Practices", “Common market opening by a maximum of two more Code of Ethics”). For example, in the case of years and the inclusion of a temporary Romania the guide refers, among others, to ways reciprocity clause applying to those Member of establishing the sale price, which is negotiable States that make use of this transitional period. and depends on the advantages offered to the This possibility applies all new Member States, retailer (discounts, bonus) and the costs of the except Bulgaria, Estonia and Slovenia – and to services provided by the retailer and invoiced Greece and Luxembourg. However, the Member onto the producer. States with derogation rights may decide to fully

liberalize their national postal markets before the Although the state-of-play in terms of end date envisaged in the Directive. competition is different in each subsector of the retail sale of new goods by specialised non-food

retailers, there are some common trends. Over ( 27 ) Initially letter mail under 350 grams, amended in 2002

the last five years a downward pressure on prices to 100 grams and reduced on 1/1/2006 to 50 grams.

European Commission

Five years of an enlarged EU

Implementation of this regulatory framework 2.5.5. Professional services

In March 2005, the transposition of the Generally the market is characterised – as in the Community framework during the period from old Member States - by a high level of entry and 1997 to 2002 had been largely completed conduct regulation. However, there is no single although there were some problems affecting a picture which characterises all the new Member number of the new Member States in particular States in this field (London Economics and RPA, (European Commission, 2005a). In 2006, all 2008). In the majority they are close to the Member States had notified the transposition of European average. However, there are some this framework, including those which joined the deviations: for example, the regulatory indicator Community in 2004 (Commission of the for legal services in Czech Republic and European Communities, 2006e). Also, the further Slovakia is one of the highest in the EU. The limiting of the reserved area (to 50 grams) on 1 Czech Republic also has one of the highest January 2006 has been transposed in all Member regulatory indicators in the EU in the field of States. accounting services.

Many National Reform Programmes (e.g. of An analysis of the concentration ratio reveals a Estonia, Poland and Cyprus) which the new lack of common trends, even when analysing the Member States have prepared in the context of most basic indicator of competition in the the Lisbon Strategy for Growth and Jobs market, i.e. the concentration ratio. This ratio is (National Reform Programmes, 2008) indicate relatively high in legal and accountancy services further progress well ahead of the deadline fixed by comparison with other subsectors and reflects for transposition of the third postal Directive. the situation in the EU as a whole. Bulgaria is

one of the countries with the highest

Effective competition concentration ratio in EU-27 (the market share of

the four largest companies is close to 80% in

In several new Member States the application of legal services and 70% in accountancy). Estonia, the EU legal framework has already led to a on the other hand, has one of the lowest scores in significant increase in competition. Romania is Europe as far as legal services are concerned (the the most impressive example, given that in market share of the four largest companies is autumn 2007 the number of existent providers on close to 20%), and Hungary is the leader in the market reached 248 as compared to 7 at the accountancy with a ratio of around 20%. end of 2001. Also the case of Poland illustrates a Hungary, in its turn, is a case that merits further significant increase in competition: in June 2007 study as far as management consultancy services there were 171 operators as compared to 90 in are concerned: the concentration ratio and profit 2004. In Slovakia, 20 postal enterprises have rates of the top companies were high in relation been registered on the basis of general permits to what is seen elsewhere, and the largest issued by the Postal Regulation Office ( 28 ). These company also has a large market share in relative developments underline the fact that full terms. On average, the concentration is definitely application of the EU framework has led to more lower on the market for architecture and competition for the benefit of the consumers, engineering services. The exceptions in this without compromising full universal services to subsector are Lithuania and Latvia, which have citizens. the highest concentration ratio in Europe (90%).

Data on profitability reflect this diversity, but not in the way that might have been expected ex ante. Profitability is higher, on average, in

( 28 ) It should however be noted that on 7.10.2008 the countries displaying low concentration ratios

Commission adopted a decision of application of Article than in those where only one or more firms are

86(3) against Slovakia in relation to so-called hybrid

mail services. The Commission found that, by reserving active. It is currently not clear whether this is due

to the postal incumbent the delivery of hybrid mail, a to government measures preventing excessive service which was so far open to competition, the profits, or whether other factors are determining

Republic of Slovakia has infringed Article 86 in

conjunction with Article 82. this outcome.

Chapter III

Goods and services in an enlarged EU

The diversified picture of the situation on the market is repeated when one looks at foreign direct investments in the sector. Cyprus and

Estonia are amongst the European leaders for which the stock of inward FDI accounts for more than 100% and 150 % respectively of domestic annual turnover. Hungary, with its 50% share, is close to the EU average, while the rest of the new Member States have lower scores. The lower rate of FDI in some countries may be evidence of a relatively underdeveloped state of competition in the markets for business services overall; however, the situation is comparable to that the old Member States. Nor is there one single picture when it comes to import penetration. Slovenia has the highest level of imports of professional services in Europe

(almost 90% of domestic annual turnover), while the other countries are at or below the average level.

Differences like this underline the conclusion that the level of and trends in competition in professional services might be dependent on the different national legislative frameworks. Several countries, such as Estonia, Lithuania and Poland, have relaxed restrictive rules on professional services, such as lawyers, notaries, accountants, architects and engineers, since their accession to the EU. Other countries, e.g. Cyprus, Bulgaria and Slovakia, are monitoring the situation in these markets. Despite these measures and attempts to open up markets, there is scope for significant improvement of the situation, and the

European Commission is enhancing the progress of reform through regular assessments under the

Lisbon Strategy for Growth and Jobs ( 29 ).

( 29 ) The latest country assessments by the European

Commission within the Lisbon Strategy for Growth and Jobs may be found at the following website: http://ec.europa.eu/growthandjobs/europeandimension/index_en.htm .

Chapter IV

Capital markets in an enlarged EU

SUMMARY OF MAIN FINDINGS

This chapter examines the role of foreign direct investment across industries and regions, in the investment and financial development in the long run there does not appear to be a strong catching-up process. Foreign direct investment correlation between regional production and makes it possible to locate activities where they income concentration in the EU resulting from can be organised most efficiently. Compared to foreign direct investment. other regions in the world, the EU attracts a higher share of foreign direct investment and in Foreign direct investment can also lead to particular the new Member States where foreign activities being shifted from old to new Member direct investment represented 27 % of gross States as firms supposedly take advantage of low fixed capital formation in 2006. Underlying this wages or taxes in these countries. While wage increase is the stable investment climate the EU level and tax competition are among the factors provides. influencing the location of foreign firms, the

relation is not straightforward. Particularly for Besides usually directly stimulating investment, services, it would appear to be the skill level exports and employment, foreign direct rather than wages that is driving offshoring. investment also makes a decisive contribution to High corporate taxes have a negative impact on growth via knowledge spill-over in various investment decisions, but do not necessarily forms: organisational imitation, tougher quality impede investment as other factors related to standards, greater variety of products and market size, availability of resources, technology increased competition which eliminates or business environment are also important. The inefficient incumbents. It is estimated that a prospects for relocation are largest in the 10 percentage point increase in the foreign direct efficiency-seeking manufacturing sector, but investment to gross fixed capital formation ratio 70% of outward direct investment from the old to raises potential growth by 0.2 percentage point. the new Member States is in the service sector

and of the market-seeking type, thus limiting the Not only greenfield investments which imply the scope for losing business. Furthermore, while in creation of new assets, but also acquisitions some sectors (e.g. food, clothing, publishing, feared to reduce competition through communication equipment, office machinery, concentration, are effective in boosting growth as motor vehicles) employment in the old Member joint ventures between foreign and domestic States is negatively correlated with the rise in partners may facilitate knowledge spillovers. employment in the new Member States, in FDI in the service sector is often thought to be several sectors (e.g. machinery, furniture, less promising in this respect because medical instruments, chemicals, tobacco) the productivity gains are harder to realise. However, opposite is true. This leads to the conclusion that to the extent that labour markets are flexible, where there is relocation, it is most often of spillovers in services can also be substantial benefit to the old Member States, essentially for because of the high labour intensity and two reasons. First, it helps maintain employee rotation in that sector. In addition, the competitiveness and can help to maintain jobs. development of modern services with a high Second, the return on the foreign investment may knowledge content and value added can be cushion adverse shocks in the home country stimulated by the shared service centres through risk-sharing. established by foreign investors.

A particularly salient aspect of the economic Foreign direct investment is often blamed for transformation in the new Member States is their widening income disparity in the host countries. rapid financial catching-up in terms of both It would seem, though, that regional income domestic financial sector development and disparities are shaped more by differences in global financial integration (in particular with the labour productivity in services than in old Member States). The new Member States manufacturing, which would make the case for a profited in particular from massive foreign direct facilitation of the free flow of services in the investment inflows, which fostered economic Internal Market and the associated foreign direct restructuring and growth – not least by driving investment. Furthermore, while there might be also the expansion of an efficient domestic some temporary concentration of foreign direct financial sector. Alongside sound macro policies,

European Commission

Five years of an enlarged EU

trade openness, and the already achieved initial large premium on strong domestic policies in the stage of development, the decisive element that framework of EU-wide coordination that ensure has attracted FDI and other capital inflows (and sound fundamentals as the new Member States

sets the new Member States apart from other continue their still long way to full convergence. emerging economies) is the coherent set of welldeveloped and proven institutions provided for In this context, fiscal policy has a particular by EU-accession. responsibility, as it can contribute significantly to maintaining macroeconomic and financial Financial intermediation in the new Member stability by compensating for expansionary States is strongly bank-based and, due to the pressures stemming from a booming private substantial FDI in the financial sector, dominated sector. It should in particular avoid proby foreign-owned banks. While this has caused cyclicality (often going beyond the stricto sensu important know-how spill-overs, it has also led requirements of the Stability and Growth Pact) to idiosyncratic stability risks in both home and and any over-estimation of structural trends in host countries – especially against the backdrop revenues and potential growth in boom phases. of the exceptional global financial turbulences In addition, structural policies play a paramount that we have been facing since 2007. role in improving flexibility in product and labour markets. This is especially relevant for the Domestic financial development and adjustment capacity of countries that have opted international financial integration have made a for currency board arrangements or that have decisive contribution to growth in the new already adopted the euro. Moreover, prudential Member States. The large capital inflows relaxed and supervisory measures constitute an important the domestic savings constraint on capital toolkit for policymakers when confronted with accumulation and allowed for total investment episodes of rapid credit growth. Not least the that substantially surpassed savings. In addition, stability risks – in both the home and host financial integration had indirect beneficial countries – associated with the high presence of effects on growth through further institutional foreign-owned banks in the new Member States development and policy discipline. Specifically require stronger national and cross-border in the financial sector, the strong involvement of policies, including enhanced regulatory and foreign banks helped to make bank restructuring supervisory coordination. and privatisation a success and rein in political involvement in credit decisions. Indirect effects In all these policy areas, the EU frameworks of global financial integration on growth and (including the Stability and Growth Pact, the economic welfare also result from new Lisbon Agenda, and the euro adoption opportunities for risk and income diversification framework) constitute powerful catalysts for and consumption smoothing. sound domestic policies – as the accession framework did before. It will be up to the new In spite of the numerous benefits of financial Member States to decide how they make use of development and integration, financial these levers for continuing their convergence convergence can raise important policy success story. challenges if capital inflows, current account deficits and domestic credit expand too rapidly, leading to an unsustainable boom and subsequent bust. Indeed, some of the new Member States have already violated related speed limits and are now faced with significant adjustment needs and potentially quite protracted growth slowdowns. In addition, the current global financial turbulences add complexity as they have encouraged international investors to take a closer look at the stability risks and vulnerabilities in emerging economies like the new Member States. All this places an additional

• 1. 

  FOREIGN DIRECT INVESTMENT AND CATCHING-UP

Section 1.1 discusses the direct and the indirect extent modify the sectoral and regional growth-enhancing mechanisms of FDI, including distribution of FDI in the Member States. diverging effects of different types of FDI, and examines if they were at work in the EU in the period of enlargement and shortly afterwards. 1.1. THE ROLE OF FDI IN ENHANCING THE

Section 1.2 focuses on the main factors which GROWTH POTENTIAL OF THE HOST attract FDI to the Member States, including the ECONOMIES impact of enlargement. Section 1.3 moves to one

of the most debated implications of FDI in the FDI ( 30 ) is likely to have both direct and indirect

enlarged EU – the relocation of production and effects on growth. Direct effects mean higher jobs. It examines the magnitude of the relocation overall investment, production and exports. across industries and discusses its possible Indirect effects include higher competitiveness of effects. Section 1.4 looks into the sectoral and domestic firms (thanks to spill-overs) and more the regional concentration of FDI and at the intensive competition. The impact of FDI in the interaction with government policies. EU is generally positive, particularly in the new

Member States. FDI would seem to have boosted economic growth in the EU, especially in the new Member The overall growth-enhancing impact of FDI is States, because of its higher share in total supported by broad country-to-country empirical investment. Moreover, several indirect comparisons, especially in the advanced mechanisms enhanced this effect, notably catching-up economies, where it complements productivity spill-overs to domestic firms. other growth factors (Borensztein, De Gregorio

and Lee, 1998; Yang, 2008). In a more detailed Foreign firms establish their production units in examination, cross-sectoral estimations based on the EU because of the attractiveness of all the an augmented production function for five old Member States, thanks to enlargement. and the EU Member States plus the US indicate that FDI growing role of cross-border production stocks had a significant and positive effect on networks (with their synergy effects). The growth. As expected, both a direct and an country-to-country disparities in FDI are indirect channel (through interaction of FDI with determined by such factors as market size, labour) were at work. The estimated impact is geographic location, quality of business sector-specific and may be absent in some environment, labour cost, exchange rate, and sectors (Vu and Noy, 2008). taxes.

1.1.1. Direct effects of FDI Both the changing competitive position in the

EU and evolving technologies in firms can lead FDI appears to play a more important role in to relocation of production and jobs in some total investment in the relatively capital-needy sectors. However, this is not a widespread new Member States compared to the capital-rich phenomenon and does not have to be negative old Member States and compared to other for the economies of origin. Relocation helps emerging countries. Moreover, this role was maintain competitiveness for corporations, increasing in time, both in absolute terms and

whose more skill-based parts of production and compared to the benchmark economies ( 31 )

ownership are still kept in the mature economies.

In addition, it spreads the risk of specialisation

and helps to smooth income. ( 30 ) Delimiting the minimum share held by a foreign investor

in a host country enterirse is the central element of the

FDI does not seem to increase sectoral definition of FDI flows. This a share at which the

concentration of production or regional income investor has a control over management. The threshold

disparities (which could, if excessive, be harmful usually applied for FDI is 10%. According to UNCTAD, the impact of differences in the applied threshold is

for catching-up) in the long term in the EU. relatively small, owing to the large proportion of FDI However, some temporary rises are possible. The which is directed to majority-owned enterprises.

EU and national regional policies can to some (

31

) The difference of shares of inward FDI in total gross fixed capital formation ratio between the new Member

European Commission

Five years of an enlarged EU

(Graph IV.1.1). Also for the old Member States, corporations). Whereas the quantitative effect FDI has become more important than for the US can be noted in all transition economies of the since the beginning of the 2000s, and its share in region, the qualitative is evident only in the new total investment was much more significant than Member States (Kutan and Vukšić, 2007). The in Japan. qualitative effect can be measured with the share of intra-industry trade (exchange of goods The ratio of FDI to gross fixed capital formation produced within the same industry) in the new was higher in the new Member States in the Member States’ trade with the old Member whole review period since the late 1990s. The states. It is possible to demonstrate a link drop in 2003 resulted mainly from the halt in between the rising intra-industry trade in the new

privatisation in the Czech Republic and Slovakia. Member States and FDI (Kawecka The enlargement helped the new Member States Wyrzykowska, 2009). to raise the ratio to a peak of 27%. The

subsequent decline resulted from a domestic 1.1.2. Indirect effects of FDI

investment boom and the inflow of EU funds. The positive externalities or spill-overs mean that

Graph IV.1.1: Importance of inward FDI in host economy a host economy may benefit not only directly as

investment described above, but also indirectly thanks to

35 Uni te d State s

% of gross fi xe d FDI having a positive impact on the productivity C hi na

capi tal formati on of domestic firms. The following mechanisms of 30 South-East Asia

Lati n Ame rica knowledge spill-overs from FDI can be

NMS

25 O MS distinguished: (i) product or organisational

(managerial) imitation, (ii) rotation of employees 20 (Fosfuri, Motta and Rønde, 2001), (iii) backward

linkages, whereby foreign investors introduce

15 tougher quality requirements for suppliers 10 (which can be backed in part by technology

transfer) or scale economies thanks to increased 5 demand, and (iv) forward linkages, which imply

a wider variety or higher quality of intermediate

0

97 98 99 00 01 02 03 04 05 06 products available locally (Kugler, 2006; Blalock and Gertler, 2008) ( 32 ). Finally, foreign entrants

Note: Inward FDI in the EU-15 does not include intra-EU-15 FDI.

For the NMS, intra-NMS FDI is subtracted for 2004-2006 only, due increase the intensity of competition, especially

to data availability, but it was not significant in the preceding years. in sectors otherwise isolated from global

Source: UNCTAD, Commission services competition (non-tradables), thereby eliminating

the most inefficient incumbents and forcing the

Besides boosting overall investment in host survivors to reduce production costs and

economies, FDI usually directly stimulates innovate.

production and exports. The analysis of export

performance of FDI in the new Member States The existence of international knowledge spilland other Central and Eastern European overs, in which FDI appears to be one of the countries shows that the positive impact has two robust channels, is supported by empirical dimensions: one quantitative (increased research (Barrell and Pain, 1999; Baldwin, production capacity) and the other qualitative Braconier and Forslid, 2005; Lee, 2006; (superior technology and managerial knowledge, Kravtsova, 2008; Smeets, 2008; Smarzynska

better information about foreign markets, integration with the supply chain of large parent

States and the average share for a further four catchingup

 economic areas (China, India, Latin America and ( 32 ) Backward and forward linkages are often analysed

South-East Asia) increased from more than 3 percentage jointly as “vertical spill-overs” and contrasted with points in 1997 to more than 11 percentage points in “horizontal spill-overs” i.e. impact on firms in the same

2006. industry.

Chapter IV

Capital markets in an enlarged EU

Box IV.1.1: Inward FDI and potential GDP growth in the EU

A simple check based on pooled crossfor the same sample, still detects a positive country data for 1991-2006 (without outliers) and statistically significant, tough smaller, points to a positive relationship between coefficient of about 0.05. The estimation is a potential GDP growth (as estimated by the panel regression with fixed country effects Commission services based on a production (favoured by Hausman test over random function) and the share of FDI in total effects), year dummies and an AR(1) investment. A 10 percentage point (which is disturbance. about ¾ of the standard deviation of FDI shares in the sample) higher FDI share Graph 1: Inward FDI and potential GDP growth in the

appears to be correlated with an almost 0.2 EU

percentage point higher GDP growth the year 10

after (significant at 5%, heteroskedasticityr t 9 ea

robust Huber-White “sandwich” estimator; y 8 ) in

Graph 1). % 7

 ( in 6

th

A non-linearity check (log-linear regression) w r o 5

shows that the impact may be even stronger P

 g 4

D

for initially low FDI ratios (up to about 17% l G 3

r ea

of total investment, which is the median of 2 a l

the considered sample). A stricter estimation n

ti 1

P o

te

which tries to extract purely intra-country 0 0 10 20 30 40 50 effects (through eliminating constant-in-time Inward FDI (% of gross fixe d capital form ation) in ye ar t-1

cross-country differences in growth,

international business cycles and inertia of Source: Commission services

growth)

Javorcik, 33 2008) ( ), but there is more compared to more developed OECD countries.

disagreement on the magnitude, mechanisms and Other spill-over effects, similar for both country timing of these effects. It should be noted that groups, are also evident (Bitzer, Geishecker and short- and long-term effects of FDI can differ. In Görg, 2008). Positive spill-overs have also been particular, spill-overs associated with FDI may detected in the largest new Member State, Poland cause a decrease in the short-term productivity (Kolasa, 2008). level (costly technological switching and

learning) and an increase in the long-term rate of 1.1.3. The effects of different types of FDI

productivity growth of domestic firms (Liu,

2008). Different types of FDI are likely to have different effects. FDI can be classified according to

Estimations based on industry-level data for 17 different dimensions, such as motive (market

OECD countries suggest that the productivity seeking or export-oriented) or entry mode (jointspill-overs from backward linkages are high in venture, acquisition, brownfield or

general, and in the new Member States (those greenfield) ( 34 ). The entry mode usually implies a

who are OECD members) in particular,

( 34 ) Greenfield investment denotes a creation of new assets

(e.g. building a factory on a previously empty site).

( 33 ) Here some multi-country studies and literature surveys Brownfield involves an acquisition of some assets (e.g. a

are indicated. Most of the analyses of spill-overs focus site with some infrastructure), which needs additional on single host countries. investment to make the project productive. It should be

European Commission

Five years of an enlarged EU

certain type of ownership structure, which is downstream industries (customers of foreignsubsequently likely to determine the channel and owned firms) and (ii) spill-overs materialised the degree of spill-overs. Governments often only with some lag (Stančik, 2009). prefer greenfield FDI, as only this type of foreign investment implies an immediate creation of new Graph IV.1.2: The role of services in foreign direct investment in

fixed assets, whereas acquisitions may entail the EU

some concentration of assets and a reduction of 80 O MS 50

competition. However, this static way of thinking % of total i nward FDI (we i ghte d ave rage ) NMS 75 45

appears to underestimate dynamic effects, 40

namely spill-overs, competitive pressure 70 35

improving the efficiency of incumbents and 65 market entry of other investors. FDI other than 30

greenfield also appears to have robust positive 60 25

effects. 55 O MS 20

NMS 15

On the one hand, a joint venture allows domestic 50 10

partners to learn technology and managerial 45 Numbe r

techniques from a foreign partner (horizontal 5 of

spill-over). It is also less costly for jointly-owned 40 0

countri e s

01 02 03 04 05 06

firms to find local suppliers and thus increases

the likelihood of local sourcing (vertical spill Note: Outliers (negative total FDI, negative FDI in services and FDI in services over 100% of total FDI) are eliminated.

overs). On the other hand, the lower the foreign Source: Commission services ownership share, i.e. control over joint venture, the lower the probability of state-of-the-art Since most services are non-tradable, service technology input by a foreign investor. All these FDI is usually market-seeking, and not directly mechanisms were at work e.g. in Romania related with trade openness (Kolstad and (Smarzynska Javorcik and Spatareanu, 2008). Villanger, 2008). Knowledge transfer in services may also take place, but the potential to increase Acquisitions by foreign investors played a productivity in this sector is smaller than in crucial role in the new Member States because of manufacturing due to the higher labour intensity. the massive privatisation during the economic Consequently, the expected growth boost thanks transition. The experience of Poland, where to FDI in services is smaller than in direct sale dominated over other privatisation manufacturing, but still observable (Lejour,

methods (Bennett, Estrin and Urga, 2007), Rojas-Romagosa and Verweij, 2008) ( 35 ). On the

shows that privatised firms acquired by foreign other hand, higher labour intensity implies that investors had higher productivity gains than the rotation of employees becomes more domestically privatised enterprises and other important as a potential spill-over channel. locally owned firms (private and state-owned). Consequently, if labour markets are flexible, This can be attributed to knowledge transfer spill-overs in services can be large. Some FDI in rather than better price-cost margins. It appears services can be also export-oriented, as in the that foreign greenfields almost immediately case of regional or even global corporate “shared positioned themselves at maximum labour service centres”. Such centres provide services productivity, to which privatised firms acquired (e.g. accounting, human resources by foreign investors gradually converged administration, software maintenance and (Modén, Norbäck and Persson, 2008). In the sometimes research) to subsidiaries owned by a Czech Republic, acquisitions could have a more corporation. The new Member States are positive horizontal spill-over effects than becoming increasingly popular locations for such greenfields. The same research also shows that centres thanks to their combination of relatively

(i) positive vertical spill-overs involved only

( 35 ) Simulations using a CGE model WorldScan show that

distinguished from an acquisition of the whole enterprise 20-35% higher FDI in services could increase GDP in with all its assets. the EU-25 by 0.4-0.8%.

Chapter IV

Capital markets in an enlarged EU

low wages and a sufficiently high skill level enlargement step and the preparations for it

(Lemagnen, 2005; Thuermer, 2006). appear to have triggered investment flows.

Almost ¾ of inward FDI since the beginning of A rough estimate of aggregate FDI in services, 1990s was attracted by Bulgaria and Romania based on incomplete samples of the old and the after the Thessaloniki Summit in 2003, which set new EU Member States compiled by Eurostat, the date for entry into the EU (Kalotay, 2008). shows that the share of FDI in services in total Not only inflows from the old Member States inward FDI was increasing much faster on were on the increase, but also FDI from other average than in the old Member States, and the countries. gap has closed recently (Graph IV.1.2). The high growth of FDI in services in the new Member Graph IV.1.3: Inward FDI in the new Member States according

States took off from a lower starting point and is to its origin

consistent with a generally increasing role of 8

services in the catching-up economies. % of GDP FDI from O MS

7 Total FDI

1.2. FACTORS WHICH DRIVE FDI IN THE EU 6

The development of transport and 5 telecommunication technologies, together with trade and capital flow liberalisation, i.e. the 4 factors which drive globalisation, appear to be the main reasons for the overall increase in FDI 3 worldwide. However, some countries attract

relatively more FDI than others. These 2 03 04 05 06

differences are likely to be shaped by several

location factors. They can be put in two groups Note: Data for EE, LT and RO for 2006 not available. Source: Eurostat

of international (affecting the whole region of the new Member States) and country-specific

effects. The international factors include There is potential for another wave of increased confidence effects thanks to the EU enlargement FDI inflows in the wake of future adoptions of and the regional synergy effects. Countrythe euro, since exchange-rate uncertainty appears specific factors comprise the economic size and to be a strong deterrent to FDI (Axarloglou and geographical location (central vs. peripheral), Kouvelis, 2007). The estimated effect of EMU macroeconomic factors (such as labour costs and was to boost inward FDI by at least 14% exchange rate changes) and the quality of the (Petroulas, 2007; European Commission, 2008d).

business environment. The simulations for the new Member States predicted inward FDI growth of between 18.5%

EU enlargement was expected to increase FDI by for Poland and 30% for Hungary — consistent boosting the confidence of investors in the with high complementarity between trade and stability and improving business environment in FDI in the region (Brouwer, Paap and Viaene, the new Member States during the run-up to 2008). The resulting macroeconomic stability accession. The announcements of political appears to be particularly appreciated by exportdecisions on EU accession had significant effects oriented FDI (Jinjarak, 2007). Again, as for EU on FDI in the new Member States during their enlargement, the endorsement of a credible euro candidacy period (Bevan and Estrin, 2004; adoption path can already stimulate FDI by Clausing and Dorobantu, 2005). The latest enhancing investors’ confidence.

enlargement appears to have stimulated FDI in

the new Member States, including from outside Besides the confidence effects, FDI in the new the old Member States (Graph IV.1.4). The Member States was likely to be stimulated by the growth in FDI from outside the old Member synergy effects of regional capital flow and trade States includes the dynamically increasing FDI liberalisation, which have been mounting since among the new Member States. And the latest the association agreements. It would seem that if

European Commission

Five years of an enlarged EU

the neighbours of an open economy attract FDI, relationship with the exchange rate is ambiguous. its attractiveness increases as it can be integrated On the one hand, investment becomes more into cross-country production and distribution expensive when the currency of the host networks (Baltagi, Egger, and Pfaffermayr, 2007; economy appreciates. On the other hand, such Blonigen et al. 2007). In addition, different kinds appreciation results from the inflow of foreign of FDI are complementary: there is a correlation capital and, in the longer term, through export between FDI in manufacturing and FDI in performance of the foreign-owned firms. producers’ services such as finance and transport Therefore, a positive relationship between the (Kolstad and Villanger, 2008). These processes two variables is a positive signal: it points to have indeed been observed in the new Member investors’ expectation of further appreciation and States. future returns offsetting the currency risk. In the

new Member States, deteriorating cost Graph IV.1.4: Inward FDI in the new Member States and competitiveness (real effective appreciation) was

possible macroeconomic factors of relocation apparently compensated by the quality upgrade

FDI as % of GDP (lhs) of their exports, not least thanks to FDI.

Re al GDP growth (l hs)

Re l ati ve profitabi l ity (2000 = 100, rhs)

Re al e ffe ci ve e xchange rate (2000 = 100, rhs) As indicated in Graph IV.1.4, real GDP growth 7 125 and profitability show the expected links with

6 120 FDI (

37 ), though the impact of profitability is 5 115 somewhat weaker. This may point to a relatively

modest share of efficiency-seeking FDI in the

4 110 past (see Section 1.3). In addition, the

3 105 relationship between labour costs and FDI may 2 100 not be obvious, even for labour-intensive sectors.

1 95 International comparisons indicate that

offshoring of services is influenced more by the

0 90

97 98 99 00 01 02 03 04 05 06 skill level and ability of employees to interact

with foreign investors than by wages

Note: The two indexes measure performance relative to the rest of 35

industrial countries with double export weights. The FDI ratio is (Bunyaratavej, Hahn and Doh, 2007). As far as

positively correlated with GDP growth (correlation coefficient of the exchange rate is concerned, FDI inflows

0.39), the exchange rate index (0.36) and the profitability index

(0.45). increased in general against real effective

Source: UNCTAD, Commission services appreciation. Simple vector autoregression, with two lags, shows that FDI contributed to this

Moving to country-specific factors of FDI appreciation. ( 38 )

location, economic “gravity models” seem to

have good explanatory power, showing that host The quality of the business environment ( 39 ) in a country size and broadly defined distance ( 36 ) to host economy appears to be another robust

the home country are the main determinants of FDI across the new Member States (Bevan and Estrin, 2004; Demekas et al., 2007; Bellak, ( 37 ) Univariate regressions: outlier-robust (based on

Leibrecht and Riedl, 2008). iteratively reweighted least squares, which assign higher weights to less deviant observations) and Arellano-Bond

(which takes into account possible endogeneity between

As implied by the gravity models, an expanding FDI and an explanatory variable through immediate

local market (measured by real GDP growth) demand effects) indicate that a 1 percentage point higher

encourages FDI, especially market-seeking real GDP growth in year t could help boost FDI/GDP by ¼ percentage point (significant at 10%). For the real

investment. Moreover, profitability (taking into effective unit labour cost index (inverted: profitability account labour productivity and labour costs) is index) the coefficient was between −0.15 and −0.2 and

likely to be positively related with FDI, in less significant.

particular efficiency-seeking projects. The (

38

) FDI/GDP higher by 1 percentage point in year t–1 explains a 6 percentage point increase in the real effective exchange rate in year t in the new Member States (significant at 1%).

( 39 ) It includes government stability, internal and external ( 36 ) Including not only transport costs but also cultural conflicts, law and order, ethnic tensions, bureaucratic

distance. quality, corruption and democratic accountability.

Chapter IV

Capital markets in an enlarged EU

determinant of FDI globally (Dollar et al., 2006; “ease of doing business” ranking. It also appears

Bénassy-Quéré et al., 2007; Busse and Hefeker, that FDI inflows correlated positively ( 41 ) with

2007; Daude and Stein, 2007) and in the new the change in the ease of doing business. The

Member States in particular (Fabry and Zeghni, reformers attracted more FDI, whereas those

2006). The quality of the business environment who lagged behind received less. appears to be very relevant, especially for smaller investors, which are essential for a host country as they are likely to stimulate 1.3. POSSIBLE RELOCATION OF competition and growth. There is empirical PRODUCTION CAPACITY AND JOBS evidence that small foreign enterprises are more

sensitive to property rights protection and 1.3.1. Factors of relocation

corruption, as they usually have lower bargaining power and often undertake more innovation FDI not only means the location of new (Lskavyan and Spatareanu, 2008). Institutional production capacity, but can also involve the quality seems more important for FDI in relocation of existing capacity abroad. The services, as they not only produce locally but relocation is influenced not only by the also sell mostly locally and often cannot switch aforementioned location factors (see Section to exports. 1.2), but also by additional location aspects at the

level of the firm and taxes.

Graph IV.1.5: The ease of doing business and FDI in the EU

Member States At the firm level, the vulnerability of industrial

18 plants to relocation seems to be positively related

)

D P 16

EE

BG to three variables: (i) the intensity of price

BE competition (cost-based competition in o f

G 14

standardised goods rather than quality-related in 6 (

% 12

0 0 differentiated goods), (ii) the inverse of sunk

-2 10 costs of setting up a plant, and (iii) the distance

0 0

5

 2 8 RO HU UK to corporate headquarters, as suggested by the I in CZ S K

LV

D 6 theory and verified by empirical analyses in LT S E

FR NL DK Spain (Aláez-Aller and Barneto-Carmona, 2008). a g

e F 4

PL IT PT v er AT FI

A 2 EL S I ES DE There is a consensus that high corporate taxation

0 has a negative impact on investment decisions

40 60 80 100

Ease of doing business (0 lowest, 100 highest) (where to invest), but not necessarily on the size of an investment (Becker and Fuest, 2007). It is

Note: The circles indicate the change in the ease of doing business

between the two periods: January 2005 – April 2006 and April 2006 – also suggested in the literature that taxes are

June 2007. Dark circles indicate positive or no change (for the likely to have an influence on the composition of

smallest circles). White circles indicate negative changes. Ireland and

Luxembourg excluded as outliers. The World Bank data is missing FDI. For instance, the geographical composition

for Cyprus and Malta. of inward FDI depends on bilateral tax

Source: World Bank (Doing Business rankings 2007 and 2008),

UNCTAD, Commission services regulations, making the bilateral corporate

effective average tax rates superior to statutory

Taking the “ease of doing business” ranking ( 40 ) tax rates in explaining FDI flows to the new of the World Bank as a measure of potential to Member States (Bellak, Leibrecht and Römisch, attract FDI based on the quality of the business 2007). The estimated impact of home country environment, we can see that better institutions taxation (of profit generated abroad) is similar to indeed coincided with higher FDI (Graph that of the host country on the probability of IV.1.5). More strikingly, most of the new location in the host country (

42

) (Barrios et al.,

Member States and only two old Member States performed above the benchmark levels under the

( 41 ) The correlation coefficient is 0.5, significant at 2%. ( 42 ) In linear estimations, the effect is 0.11 percentage point

( 40 ) The ranking is normalised so that 100 denotes the best of probability of location per percentage point lower

global rank and 0 the worst global rank. corporate tax rate for a host country and 0.07 for a home European Commission

Five years of an enlarged EU

2008). In addition, declining statutory and IV.1.1). Some manufacture of food products and effective tax rates in Europe indicate competition beverages, publishing, printing and reproduction for foreign investors (Elschner and Overesch, of recorded media, manufacture of office 2007). Other taxes are also relevant to FDI machinery, computers and motor vehicles might location decisions. This includes social have been subject to relocation, especially since contributions related to wages (Bellak, Leibrecht enlargement. On the other hand, for many other and Riedl, 2008). industries there is no clear correlation. For important industries such as chemicals, medical,

1.3.2. The scale of relocation in the EU precision and optical instruments, other

specialised machinery and equipment, furniture The scale of relocation in the EU and in specific and wood product manufacture, there is a industries can be measured in different ways. positive correlation between employment in the First, the relocation of production capacity old and the new Member States. The results from substitution of investment in some employment in tobacco industry was relocated Member States through investment in others by outside the EU. the same corporations. Second, we can look at the relocation of jobs in different locations in the Comprehensive evidence from five old Member same industries. Third, relocation of a part of a States (Austria, Finland, Germany, Italy and the production chain will mean an increasing share Netherlands) of the employment effects of of trade in intermediate goods. outsourcing services to European and non

European low-wage countries (Falk and Recent firm-level research suggests that German Wolfmayr, 2008) shows that: (i) in the non FDI in the new Member States is complementary manufacturing sector, the effect is negative but rather than competing with German FDI in the rather small (decreased employment by 0.2

“old EU periphery” or the “core” in general. On 43 percentage points per year in 1995-2000) ( ); (ii)

the other hand, poor performance at traditional in the manufacturing sector, outsourcing of locations is not generally correlated with services is not significant and the outsourcing of investment expansion in the new Member States. intermediate materials also had a relatively small There are a few likely reasons for that negative impact. Strikingly, the effect is larger (Jungnickel et al., 2008): (i) the operation of EU- for intermediate materials from Asian emerging

wide production networks with dispersed value economies than the new Member States. chains, in some industries, (ii) the dominance of market-oriented FDI (in contrast to efficiency The prevalence of a positive relationship seeking or cost-motivated), in other industries, between outward FDI and employment in a and (iii) a possible simultaneous relocation home country is demonstrated by research to/from the old and the new Member States focused on Italy, a Member State potentially from/to outside the EU. The comparative subject to high relocation because of a relatively advantages of German exports have been high share of labour-intensive production (Scott, reinforced by the development of complementary 2006) and with a less friendly business manufacturing base of German corporations in environment than most of the other old Member the new Member States (Box IV.1.2). States (Graph IV.1.5). Rather than reducing overall employment, FDI in the new Member A simple check on whether jobs are being States contributed to a skill upgrade in parent relocated, based on a sample of more than 23 000 companies in Italy (Castellani, Mariotti and EU manufacturing firms with more than 200 Piscitello, 2008). employees sourced from the Amadeus database, shows that there may be some relocation to the new Member States in selected industries, but it is not a common or prevailing pattern (Table

( 43 ) Moreover, the type of outsourced services matters: no

country corporate tax. In logit estimations, the latter negative employment effects of business services coefficient is higher than the former. outsourcing have been identified.

Chapter IV

Capital markets in an enlarged EU

Box IV.1.2: Enlargement and the German economy

For Germany, enlargement offered on the one FDI stock suggests that investments are hand, access to a rapidly growing market. On the becoming gradually more capital-intensive. other hand, low wages in the East were perceived as a threat to production in Germany. This box One third of German FDI investment in the new presents some stylised facts on the economic Member States went to the Czech Republic; linkages between Germany and its eastern Hungary has a share of 29%, Poland 24%, neighbours. Slovakia 10%. Slovenia and the Baltic states play

practically no role in the investment strategy of FDI flows between Germany and the NMS are a German companies. Employment in individual one-way street. While FDI in Germany is countries is roughly in proportion to investment negligible, available statistics currently place the volumes. However, while investment in the value of German FDI stock in the EU-10 Czech Republic is one third higher than in Poland countries at around € 60 bn, about 1% of the in financial terms, employment in the two German capital stock. The build-up of FDI countries is nearly identical. Prima facie this occurred very rapidly from a low base in the indicates that investment in the Czech Republic is early 1990. Most of the current stock (nearly 2/3) relatively capital intensive. However, this should was built up ahead of enlargement proper in 2004 not be over-interpreted, as it might be driven by a (Graph 1). single investment (Volkswagen's purchase of

Skoda).

Graph 1: Cumulated German investment in the new

Member States Graph 2: German trade

60 bn. € 1200 bn. € bn. € 120

HU

SI Total e xports (lh s) 50 SK 1000

Total imports (lhs) 100

C Z Exports to NMS (rhs) 40 PL

Baltics 800

Imports from NMS (rhs) 80

30 600 60

20 400 40

10 200 20

0 0 0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: Bundesbank Source: Comext

Actual investment volumes are likely The increase in FDI has been paralleled by a underestimated somewhat, because a statistical significant increase in the growth of bilateral change in 2002, which reduced the number of trade flows, which surpassed the growth rate of reporting firms by nearly half, led to a break in the already rapidly rising international trade the series. Consequently, the seeming slowdown volume. Currently, imports from the new of FDI flows in 2002/3 is unlikely to reflect real Member States amount to about 10% of total developments. imports of Germany. Just like with the rest of the

world, Germany has a sizable and rising trade

Employment by German companies in the NMS surplus with the NMS area (Graph 2). However, rose in parallel from some 100 000 in 1992 to while globally Germany is a net exporter of nearly 700 000 in 2001. Since then, only about medium-high tech goods and relatively weak in 100 000 jobs were created. The slowdown in job high tech and low tech, the specialisation vis-à- creation in combination with a continuing rise in vis the new Member States is inverted (Graph 3).

Here Germany is a net exporter of high-tech

(Continued on the next page) European Commission

Five years of an enlarged EU

Box (continued)

goods, while the comparative advantage in Second, production might have located further medium-tech goods disappears. Noteworthy here away with consequently weaker supply links with is that in car manufacturing, one of Germany's the mother company. strongest export sectors, Germany has a substantial trade deficit with Central Europe. In short, Germany appears to benefit substantially However, some of this might reflect transfrom the economic developments of its eastern shipments by German mother companies to other neighbours. countries.

Graph 3: Revealed comparative advantage of

In summary, Germany's economic cooperation Germany

with the new Member States is becoming increasingly close. The trade surplus indicates W orld Motor ve hi cl es

that, in the aggregate, the growth of the central NMS

European manufacturing base has not come at the C h e micals

expense of production in Germany. The IC T

increasing bilateral trade flows also suggest that in many sectors only parts of the low end of the Low tech value added chain have been located in the East, Me dium l ow leaving production in Germany to specialise in tech the high value end. This implies productivity Me dium h igh

gains and a strengthening of the remaining te ch Re ve ale d com parati ve advantage

industrial base in Germany. This is so, in Hi gh te ch

particular, when considering what might have -0.5 0.0 0.5 1.0 1.5

happened had German companies not invested or outsourced in the new Member States. First, Note: Revealed by comparative advantage calculated as (X-

German companies might have closed down M)/M corrected for total net trade balance. Source: OECD (STAN Bilateral Trade Database)

completely rather than outsourcing a part of production.

The choice of organisational form for shifting the favour intra-firm offshoring (Marin, 2006). The production capacity abroad can be either level and growth of outsourcing and offshoring international outsourcing or intra-firm by the old in the new Member States (as offshoring. Outsourcing denotes shifting internal measured by trade in intermediate products) business processes to an external company, seems to have reached its peak at the moment of domestically or abroad. Offshoring means that a enlargement and levelled off since then, business process done at a company in one compared to declining indicators for other

country is shifted to the same or another exporting areas (Graph IV.1.6). company in another country. The choice between international outsourcing and intra-firm To conclude, empirical research shows that it is offshoring is determined by information mostly efficiency-seeking FDI in manufacturing technologies, industry-specific technological where relocation is most intensive. The existing factors and country-specific institutional stock of efficiency-seeking FDI in the new features. In the new Member States, falling trade Member States in relation to the overall old costs and corruption, along with improvements Member States' outward FDI is not large

in the contracting environment in the new (roughly 1 /5), so the scale of relocation hitherto

Member States, stimulate international could not be high from the perspective of the old outsourcing. On the other hand, low Member States. Moreover, a large part of the organisational costs of hierarchies (related to the efficiency-seeking FDI did not involve any

development of information technologies) and relocation – rather the opposite. the high costs of hold-up in a given industry (related to the scarcity of alternative suppliers)

Chapter IV

Capital markets in an enlarged EU

Table IV.1.1: Correlation of average employment in manufacturing enterprises in the old and the new Member States, 1998-2007

Manufacturing industry (NACE 2-digit) Correlation Trend in the NMS

Food products and beverages -0.96 *** +

Wearing apparel; dressing and dyeing of fur -0.84 *** =

Publishing, printing and reproduction of recorded media -0.79 *** +

Pulp, paper and paper products -0.78 *** =

Radio, television and communication equipment and apparatus -0.73 ** =

Office machinery and computers -0.70 ** +

Motor vehicles, trailers and semi-trailers -0.64 ** +

Recycling -0.59 * +

Coke, refined petroleum products and nuclear fuel -0.22 +

Rubber and plastic products -0.07 +

Fabricated metal products, except machinery and equipment 0.12 =

Electrical machinery and apparatus n.e.c 0.33 +

Basic metals 0.33 -

Textiles 0.50 -

Tanning and dressing of leather; luggage, handbags, saddlery, harness and footwear 0.50 -

Other non-metallic mineral products 0.61 * =

Other transport equipment 0.65 ** =

Tobacco products 0.79 *** -

Wood and of products of wood and cork, except furniture; articles of straw and plaiting materials 0.85 *** =

Chemicals and chemical products 0.86 *** =

Medical, precision and optical instruments, watches and clocks 0.90 *** +

Furniture; manufacturing n.e.c 0.95 *** + Machinery and equipment n.e.c 0.95 *** =

Note: The employment figures have been adjusted for common business cycles: for each year, average employment in an industry was divided by the average employment of all industries. Correlation coefficients significant at *** 1%, ** 5%, * 10%.

Source: Amadeus, Commission services

Graph IV.1.6: Intermediate imports by old Member States from import-dependent (see the discussion on the

selected country groups international production chains in Section 1.3.3

30 % of i mports by O MS from below). Medium-technology industries – such as re spe cti ve country group transport equipment, machinery, chemicals

25 (excluding pharmaceuticals), rubber and plastics products, metal products – have been subject to

20 the highest relocation currently (Rojec and Damijan, 2008). This observation is consistent

15 with the finding that the new Member States are most competitive in medium-technology

10 NMS industries (see Chapter III.1.4).

Intra O MS 5

Re st of the worl d 1.3.3. The benefits of relocation for the old

0 Member States

99 00 01 02 03 04 05 06 07

Even if some relocation is taking place, it is

Note: Intermediate goods are defined as parts and accessories of

capital goods (including parts and accessories for transport likely to be beneficial to the old Member States.

equipment) as classified according to the UN trade statistics Broad Two important benefits are described below:

Economic Categories.

Source: Commission services maintaining competitiveness and risk sharing.

The overall net impact on jobs in investors' The old Member States can retain their economies of origin can be positive because competitiveness, despite high wages, because foreign subsidiaries in new Member States are they keep on producing high-technology

not only highly export-oriented, but also highly components of complex final products as well as designing these final goods and developing the

European Commission

Five years of an enlarged EU

technologies proper. However, the production of and Razin, 1978; Kalemli-Ozcan, Sørensen and

final products continues to need labour-intensive Yosha, 2003).

ingredients or routine tasks (Robert-Nicoud,

2007). These complementarities can be exploited In 2003-2006, higher domestic demand growth

by outsourcing or offshoring parts of the in the old Member States appears to have been

production chain to the new Member States. The accompanied by lower growth in income from

assembly of complex products and the FDI (Graph IV.1.7). In the depicted phase of the

international production chain are managed by business cycle, it was apparently not necessary to

large corporations which, through FDI, acquire repatriate profits generated by the high FDI in

or establish subsidiaries in both country groups. the new Member States to smooth income. The

The share of “vertical FDI” (investment in data is still too limited to make strong

subsidiaries which provide inputs to their parent judgements, but it is likely that, in the current

firms) is larger than commonly perceived. phase of the cycle with a severe downturn in the

However, this can be fully observed only with a mature economies, income from FDI will to

sufficiently disaggregated product classification. some extent compensate for smaller profits in the

A comprehensive empirical analysis ( 44 ) shows home economies.

that the closer the production stage is to the final product, the more likely it is for a multinational corporation to own a supplier. This type of 1.4. The sectoral and regional dimensions “vertical FDI”, which disperses the production of proximate components, does not seem to be well On the one hand, FDI is likely to stimulate explained by the traditional comparative growth but, on the other, it is blamed for advantage models (location of low-technology increasing income inequalities in the host production stages abroad in labour abundant economies (Basu and Guariglia, 2007). Since countries) (Alfaro and Charlton, 2007). over-specialisation is risky and excessive inequalities are harmful to durable growth, it is Graph IV.1.7: Domestic demand in the old Member States and worth examining if FDI increased imbalances in

income from FDI in the new Member States any of these two dimensions.

100 2.8

The EU integration process is reducing the role

2.6 Re al dome sti c

80 de mand growth of countries in attracting FDI and making regions

(e xcl. inve ntorie s) more similar. This implies that each region can

2.4 i n the e uroz one

(rhs) compete for FDI (Pusterla and Resmini, 2007).

60 Additionally, the EU and the national regional

2.2 policies influence the relationship between FDI 40 and regional production and income dispersion.

2.0 Re al growth of

i ncome from O MS's FDI in the

20 NMS (l hs) Combining regional and sectoral analysis, the

1.8 regional income disparities in the old Member States, as determined by differences in labour

0 1.6

04 05 06 productivity, seem to be shaped by services

rather than manufacturing (Fotopoulos, 2008).

Note: The time series is determined by data availability.

Source: Commission services This points to the need for an even freer flow of

services in the internal market to help speed up

Relocation mirrors specialisation patterns. If the FDI in services.

specialisation risk (see Section 1.4 below) can be

“insured” with trade in assets, specifically Aggregate data do not indicate that there is a big acquiring ownership of foreign enterprises, the danger of industrial or regional production and

net benefits of specialisation are larger (Helpman income concentrations in the EU resulting from high FDI in the long term. However, there may

be some temporary increases in FDI

( 44 ) Covering a global sample of 650 000 subsidiaries of concentration across industries and regions, as

multinational corporations. well as clustering within regions. Somewhat

Chapter IV

Capital markets in an enlarged EU

higher concentration does not have to be bad for new Member States experienced any dramatic growth as it helps to make best use of increase in concentration after enlargement. agglomeration economies.

1.4.2. The regional concentration of FDI 1.4.1. The sectoral concentration of FDI

The location of FDI inside countries is affected Specialisation gives competitive advantages by agglomeration economies. These are the thanks to economies of scale, at a cost of higher benefits which firms obtain when locating close variance of output (Ruffin, 1974). The to each other in large numbers, leading to the dominance of a small number of industries can creation of clusters of certain industries; those be risky for an economy, as it makes it more which are capital-intensive lead to scale susceptible to shocks. If FDI is concentrated in economies, while those which are laboursome sectors or industries it can increase such intensive lead to increases in wages. It should dependence. According to inward FDI data also be noted that, beyond certain threshold of disaggregated by the Eurostat/OECD firm concentration, the agglomeration economies classification of activities (covering the whole may disappear and negative externalities

economy, not only manufacturing) ( 45 ), the resulting from congestion can emerge.

concentration was lower in the new Member Agglomeration economies, together with the

States than in the old ones (Graph IV.1.8). relevance of past experience for location decisions (investors tend to prefer known

Graph IV.1.8: The sectoral concentration of inward FDI countries and regions), contribute to inertia and

0.6 some persistence of either low or high FDI O MS flows. In the following paragraphs, the short

NMS

0.5 term experience of FDI location inside some old Member States based on microeconomic studies

0.4 is summarised. Subsequently, some evidence from the new Member States is presented.

0.3 Finally, the long-term relationship between FDI and regional dispersion in the two country

0.2 groups is compared, based on aggregate data.

0.1 The risk of escalating disparities between regions in terms of capital-to-labour stock ratio due to

0 FDI and sharply rising regional wages is

97 98 99 00 01 02 03 04 05 06 alleviated by the complementarity of capital and

Note: Concentration is measured with the Herfindahl-Hirschman labour flows. The agglomeration forces seem to

index (0 lowest concentration, 1 highest). The index is the sum of

squared shares. have attracted both foreign investors and

Source: Commission services migrants to the same locations in Germany

(Buch, Kleinert and Toubal, 2006). This is contrary to the expectations that the new

Member States might be more susceptible to In France, FDI location decisions revealed the such concentration because of the smaller size of following tendencies: (i) industries with high their economies. Besides, neither the old nor the scale economies (computers, car parts, machine

tools and office machinery) were subject to the strongest agglomeration effects and (ii) a learning process was taking place in location

( 45 ) In the present analysis, FDI in manufacturing was choice over time: foreign investors from

disaggregated into 15 industries due to possible high

variance of FDI in different industries across countries, neighbouring countries were moving first to

whereas non-manufacturing FDI was disaggregated in regions close to their origin and then dispersing

broader sectors (such as agriculture and fishing, mining over the whole host territory (towards the places

and quarrying, electricity gas and water, construction,

trade and repairs, hotels and restaurants; transport, with higher demand for their goods) (Crozet,

storage and communication, financial intermediation, Mayer and Mucchielli, 2004).

real estate, renting and other business activities).

European Commission

Five years of an enlarged EU

The empirical evidence from the UK is that, new Member States (geographical concentration while clusters intensify productivity spill-overs close to a random distribution). Overall, the from FDI, this only occurs in pre-existing regional concentration in the countries which clusters, where domestic firms already have joined the EU in 2004 looks lower than in mature gained some collaborative experience. FDI- economies (such as the old Member States or the generated clusters can also disappear since US). Higher regional concentration than in the foreign-owned firms are very mobile (De Propris old Member States was detected only for new and Driffield, 2006). information technologies, biopharmaceuticals and communications equipment (Sölvell, Ketels

An analysis of the Italian experience tries to split and Lindqvist, 2008). the agglomeration effect according to two possible channels: (i) the benefits of The regional dispersion is changing slowly in specialisation and (ii) the benefits of most of the countries, so we can take an diversification (wider choice of intermediate additional look at differences in dispersion across goods and more intense competition among countries and at a long-term indicator of foreign suppliers in agglomerations). The former were investment penetration such as FDI stock. detected, but the latter were not. In addition, FDI Consistent with no clear conclusions in the turned out to be lower in locations dominated by literature, the aggregate data point to the lack of small enterprises (Bronzini, 2008). an evident long-term link between the two variables (Graph IV.1.9). Spanish experience shows that inward FDI can enhance the inertia and path-dependency in Graph IV.1.9: The FDI stock and regional GDP dispersion in the

regional development due to agglomeration EU

economies. Especially FDI in manufacturing of 60 higher-end complex products, in which LV

integration into large production networks is a i

n 50

necessity, is strongly attracted to regions which a

p it

a

HU EE

already have a high level of manufacturing and e

r c 40 NMS

R&D activities. On the other hand, cost-oriented D

P p RO SK BG

G 5 30 FDI in manufacturing of less-processed simpler n a

l

2 0

0

EL DE PT BE UK

IT AT IE

products, which seem to be less mindful of e g

io LT

f r 20 SI

FR C Z

agglomeration economies, are attracted by high o FI

NL ES

o n SE O MS

factor endowments (Pelegrín and Bolancé, e r si 10

2008). is p MT D

0

Turning to the new Member States, there is no 0 20 40 60 80 100 120 140 FDI stock as % of GDP i n 2005

convincing evidence of an impact of FDI on

inter-regional concentration of business activity Note: The dispersion of regional GDP (at NUTS-3 level) is measured by the sum of the population-weighted absolute differences between

in the 1990s following the rapid elimination of regional and national GDP per capita, and expressed in % of the

trade barriers and liberalisation of capital flows national GDP per capita. Source: UNCTAD, Commission services

in these transition economies (Altomonte, 2007). In the following years, FDI helped create several

regional clusters inside regions, including 19 1.4.3. The interaction of government policies large ones ( 46 ). Nevertheless, the process of with the regional effects of FDI

regional concentration and redistribution of

industry appears to be in an early phase in the Special zones with corporate income tax reduction and location-specific subsidies appear

to be jointly the most popular tool for attracting FDI in the new Member States (Cass, 2007). In

( 46 ) Large clusters were defined as those with (i) more than this way, authorities may shape the geographic

10 000 employees, (ii) a specific sector in employment in

a region accounting for at least twice its share in the total pattern of FDI location and counteract possible

economy and (iii) a particular sector in a region excessive concentration, but they also risk employing more than 3% of total employment in the distorting competition (especially if this aid is

economy.

Chapter IV

Capital markets in an enlarged EU

vertical, i.e. awarded to selected industries and firms) and preserving regional dependence on transfers; once this artificial advantage expires, simultaneous mass disinvestment may take place.

In the EU, there are two more factors which may interact with the link between FDI and regional discrepancies: the EU cohesion policy and the

FDI motives as shaped by the existence of the

Single Market. FDI location decisions in the old

Member States’ periphery seem to have been influenced by cohesion policy. Firm-level data from eight old Member States shows that structural and cohesion funds allocated by the

EU to underdeveloped regions contributed to attracting FDI in the 1990s. In addition, EU investors preferred regions with lower wages and per-capita income compared to investors from non-EU countries. The European investors appear to have tended to re-organise their production networks to exploit the opportunities offered by the Single Market (a mix of production costs reduction and an expansion of market access). In contrast, the extra-European investors sought the wealthiest markets as well as locations with skilled workers and advanced technologies (Basile, Castellani and Zanfei,

2008). Hence, it is mainly intra-EU FDI which is expected to contribute to convergence of income per head.

• 2. 

  FINANCIAL INTEGRATION AND FINANCIAL SECTOR

  DEVELOPMENT

Financial integration and development have particular with the old Member States and the proceeded rapidly in the new Member States. euro area. Both developments have offered a This chapter explores to what extent this has broader spectrum of opportunities for market been to the benefit of these countries. It also participants. In the following, domestic financial discusses stability challenges on what is still a development will be reviewed first and financial long road to full convergence. These challenges integration second. This will offer the proper have considerably increased with the current ground for examining how these developments global financial turbulences (see Box IV.2.1). were related to accession, and in particular to the

European Union's institutional framework, and to The key conclusions are as follows: Financial what extent expected benefits of financial integration in the new Member States featured in catching-up have materialized. particular high and growth-enhancing FDI

inflows. The comparatively good institutions 2.1.1. Financial sector development

resulting from EU accession have played a catalytic role in attracting such inflows. FDI has Financial sector development in the new Member also been strong in the financial sector and has States was initiated by a process of bank driven its development, leading to a dominance restructuring and privatisation, i.e. the removal of foreign-owned banks. The latter has caused of government control on credit markets, substantial know-how spillovers but – against the facilitating the access of the corporate sector and backdrop of the exceptional global financial households to credit. It also received an turbulences that we have been facing since 2007 important impetus from abroad through FDI (see – it also led to specific stability risks in both the next section). Overall, with the notable exception home and host countries. The containment of of Cyprus and Malta, the catching-up of the these risks requires strengthened national and financial sector in the new Member States to the cross-border policies, including enhanced euro area level has not been completed yet, regulatory and supervisory co-operation. In a despite remarkable progress. more general vein, the global financial turbulences have encouraged international Graph IV.2.1: Structure of financial markets in the Member

investors to scrutinise more thoroughly the States, 2008

stability risks and vulnerabilities associated with 140 % of GDP financial catching-up. They have thus placed an

additional focus on strong domestic policies that 120

dome sti c cre di t, Nov. 2008 de bt se curi tie s, De c. 2006

help prevent excessive credit growth and current stock marke t capi tali sati on, De c. 2008 100

account deficits and ensure sound fundamentals.

In this context, the importance of the EU policy 80 frameworks and of EU-wide and international

cooperation to support national policies has been 60

amply underscored. 40

20

2.1. FINANCIAL SECTOR DEVELOPMENT AND

INTEGRATION 0 BG C Z EE HU LV LT PL RO SK SI EA

In the financial area, the transition from a Note: EA stands for the unweighted average at 12 members. MT and CY: 144 % and 225 % of GDP for domestic credit, and 66 % and 104

centrally planned to a market-based economy % of GDP for debt securities.

and EU-accession implied two related processes. Source: ECB and national sources

First, there has been substantial growth in

domestic financial intermediation. Second, the A key characteristic of the new Member States is domestic markets for financial services have that financial intermediation is strongly bankbecome

 more and more integrated globally, in

Chapter IV

Capital markets in an enlarged EU

Box IV.2.1: Impact of the global financial crisis on the new Member States

The current global financial and economic crisis Graph 1: Exchange rate developments in selected new

has been spreading to the new Member States Member States, 2007-2008

through different channels. Prominent among 70 them are a slowdown in trade and investment and

potential changes in the funding and business CZK HUF 80

strategy of some financial institutions towards PLN RO N their subsidiaries in the new Member States. 90 Tensions in the different segments of financial markets, especially in money and credit markets, 100 have increased, leading to a deceleration in credit growth. The deterioration in financial market 110 conditions in the new Member States reflects

higher risk aversion, against the background of a 120 de pre ciati on

worsening global economic outlook and financial sector deleveraging. Short-term interest rate 130 spreads have widened substantially, indicating 07 08 tighter liquidity conditions. Increasing country Source: Commission services risk perceptions have resulted in a strong rise in

credit default swap (CDS) spreads. Moreover, the multilateral financing packages together with the exchange rates of floating currencies have IMF and other international financial institutions weakened following a period of sustained (as well as, in the case of Latvia, other Member appreciation in some cases (see Graph 1). States).

Countries with home-grown vulnerabilities such

as major macro-imbalances appear to be the most At the same time, the ceiling for the EU financial affected by the crisis, with spillovers to the real assistance under the balance of payments facility economy being felt accordingly. was raised from 12 billion to 25 billion EUR to

enhance significantly the capacity of the

In some new Member States this has even led to European Union to cope with potential further the need for external assistance. In such cases, the external financing needs of the Member States EU stands ready to provide such assistance. outside the euro area. Moreover, to address short Based on Commission proposals, the Council term liquidity needs in euro, the ECB has adopted decisions providing medium-term established repurchase facilities with Hungary financial assistance to Hungary (up to 6.5 billion and Poland amounting to 5 and 10 billion EUR, EUR) and Latvia (up to 3.1 billion EUR) to respectively. The Swiss National Bank also overcome short-term external liquidity shortages entered into a CHF-euro swap agreement with the and support a return to balance-of-payments National Bank of Poland to address needs for sustainability in the medium term. Financial CHF liquidity in the market (against the support has been linked to the fulfilment of background of widespread CHF-denominated comprehensive economic policy conditions and lending).

has been provided in the context of broader

dominated, while direct finance plays only a market value of equities in the Baltic countries

minor role (Graph IV.2.1).( 47 ) Nevertheless, a and Slovakia. On the other hand, in Poland and

more disaggregated analysis reveals differences the Czech Republic bank credits lag slightly among countries. On the one hand, total behind total stock market capitalisation. domestic credit amounts to 2½ to 9½ times the However, such data needs to be read cautiously,

given that the share of actively traded stocks in the new Member States is relatively low.

( 47 ) For this reason, this section concentrates on the banking

sector. For an analysis of e.g. the insurance sector, see

European Financial Integration Report 2008, European The ratio of outstanding credit to GDP has been

Commission, Staff Working Document, 2009. growing steadily over the last decade in all

ropean Commission

Five years of an enlarged EU

countries except the Czech Republic and improved risk management as well as better

Slovakia where the banking sector was corporate governance.

restructured and privatised relatively late (Graph

IV.2.2). The speed of bank credit expansion is Graph IV.2.3: Concentration of the banking sector in the new

characterised by two salient features. Member States, 2001-2007

120 share of 5 large st banks in total bank asse ts

Graph IV.2.2: Total bank credit to the non-financial private

sector 100 2001 2004 2007

140 % of GDP 80

120 1997 2004 O ct. 2008

60 100

80 40

60 20

40 0

BG C Y C Z EE HU LV LT MT PL RO SK SI EA 20

Note: EA - unweighted average at 12 members. Source: ECB

0 BG C Z EE HU LV LT PL RO SK SI EA

Note: Data for SI is for December 2006. MT and CY already reached However, recent global financial market

euro area levels: 94% and 142% of GDP in 1997, 107% and 165% of turbulences have also highlighted the specific

GDP in 2004, and 118% and 206% of GDP in 2007.

Source: IMF risks associated with this characteristic of

financial market development in the new

The first refers to the generally high level of Member States.

concentration among banks (Graph IV.2.3), in

particular in Estonia and Lithuania. There is no Graph IV.2.4: Foreign ownership in the banking sector in the new Member States

clear trend after EU-accession. Since then 120

concentration has, for instance, decreased % 1998 2003 2007

slightly in Poland and Slovenia, but increased in 100 Lithuania and Latvia. Over a longer time horizon, concentration has remained relatively 80 constant. The second distinctive feature of the

banking sector in the new Member States 60

concerns its high level of foreign ownership 40

(Graph IV.2.4). In Estonia, Lithuania and Slovakia, the banking system is almost entirely 20 foreign-owned, while participation from abroad

in the other new Member States is, on average, 0 BG C Z EE HU LV LT PL RO SK SI EA

four times higher than in the euro area, with

Slovenia having the lowest foreign participation. Note: EA - unweighted average at 12 members. Source: ECB

This second distinctive characteristic presents a

strong correlation with the accession process. Direct finance has developed significantly less The prospects in the new Member States than the banking sector. Initially boosted by attracted foreign investors, especially from the public offerings as part of the privatisation old Member States, well in advance of the date schemes, stock market liquidity has decreased in of enlargement. Strong FDI in the financial many countries (Graph IV.2.5). Poland, Hungary sector, spurred by the privatisation process, and the Czech Republic appear to be the

transferred not only capital but also more economies with the most liquid stock markets.

diversified and innovative financial products and

Chapter IV

Capital markets in an enlarged EU

Graph IV.2.5: Stock market liquidity, 2000-2007 exception, partly because the introduction of a

140 tradi ng vol ume as % of marke t capi tal i sati on mandatory funded pension pillar in their

economies contributed to the development of

120

2000 2004 2005 2007 non-bank financial intermediaries.

100

2.1.2. Financial sector integration

80

Financial sector development in the new Member 60 States was accompanied by their integration in

the EU market for financial services and

40 associated with substantial capital inflows. 20 Financial integration can be measured by the

convergence of prices for similar financial 0 services and quantitatively, e.g. by cross-border

BG C Z EE HU LV LT PL RO SK SI ESE assets and liabilities.

Note: ESE - Euronext stock exchange.

Source: EBRD Euronext Year Books Graph IV.2.7: Distribution of total financial assets, 2007

Debt securities markets are dominated by C re di t insti tuti ons Insurance corporati ons % Inve stme nt funds Pe nsi on funds

government securities (with the notable 100 exception of Estonia where corporate debt remains nevertheless very low relative to bank 80 credits) and therefore do not represent a genuine means of financing economic activity (Graph 60

IV.2.6). However, the lack of sizeable corporate

bond markets should not be overemphasised, as 40

financing from abroad could act as an efficient

substitute. 20

Graph IV.2.6: Structure of the debt securities markets, 2006

0 gove rnme nt fi nanci al i nstitutions corporati ons BG C Y C Z EE HU LV LT MT PL SK SI EA i nstrume nts by i ssue r as % of total outstandi ng amounts

100 Note: Missing data on RO and CY.

Source: ECB

80

As regards price convergence, spreads between

60 lending and deposit rates have been lowered

towards euro area levels (Graph IV.2.8). This benefit was already reaped in the pre-accession

40 period, when the preparations for joining the EU

supported liberalisation and competition.

20 Furthermore, both short-term and long-term

interest rates in the new Member States have

0

BG C Y C Z EE HU LV LT MT PL RO SK SI EA converged toward the euro area levels and the

differences vis-à-vis these levels have become

Source: ECB more uniform between countries (Graph IV.2.9).

This relative underdevelopment of direct finance This price convergence, while advanced by the in the new Member States means that there are accession process (including macroeconomic only limited domestic investment opportunities stabilisation), has taken place in a global for insurance corporations and other institutional environment of sustained growth and low investors (e.g. pension funds). The share of total inflation that favoured all emerging markets. It financial assets managed by them remains low has partly been reversed during the recent (Graph IV.2.7). Poland and Hungary are an financial market turbulences.

ropean Commission

Five years of an enlarged EU

Graph IV.2.8: Lending and deposit rate spreads, 1998-2008 The strongest contribution to that increase has

12 EE come from FDI, which has gained in importance

% LT

LV since the mid-90s and reached 8.1% of GDP in

10 PL 2007 (in terms of annual gross inflows). Portfolio

HU

C Z investment has played a much less important role

8 SK than FDI in the new Member States, given in

BG

EA particular their underdeveloped stock markets. It

6 reached its peak of 4.0% of GDP in 2004, before declining to 0.7% of GDP in 2007 (again gross

4 inflows). Other investment, which includes intra(financial and non-financial) company loans, has

2 played a significantly increasing role since 2002. It amounted to 11.8% of GDP in 2007, even

0 outweighing FDI.

98 99 00 01 02 03 04 05 06 07 08

Note: SI, MT, CY - missing observations; RO not represented (37% Graph IV.2.10: External assets and liabilities of the new Member in 1998 and 6.7% in 2007); data for 2008 as of October. States, 2000-2007

Source: IMF

500 % of GDP

In quantitative terms, the financial integration of

the new Member States can be measured by the 400 2001 2006 total sum of external assets and liabilities related 2000 2007

to GDP (Lane, 2003). It increased from 76% of 300 GDP at the end of 2000 to 150% of GDP at the end of 2006 (Graph IV.2.10). The average ratio

of total foreign assets to GDP increased from 19 200

% in 2000 to 41 % in 2006, while the average 2006

ratio of total foreign liabilities to GDP rose from 100

57 % in 2000 to 109 % in 2006.( 48 )

0

Graph IV.2.9: Convergence of interest rates, 1999-2008 BG C Y C Z EE HU LV LT MT PL RO SK SI

25 5 Note: Data without foreign exchange reserves.

% ave rage , short-te rm spre ads (l .h.s) % Source: Eurostat

standard de vi ati on, short-te rm spre ads (l.h.s)

20 ave rage , l ong-te rm spre ads (r.h.s) 4

standard de vi ati on, long-te rm spre ads (r.h.s) FDI can be considered to be the most important form of capital inflows from at least two angles.

15 3 First, FDI has enhanced the conditions for the other forms of capital inflows. Second, a

10 2 substantial part of FDI has been realised in the

financial sector, propelling its development, leading to the high degree of foreign ownership,

5 1 and opening up refinancing possibilities from

abroad for foreign-owned banks that contributed 0 0 to the substantial bank credit expansion(

49 ). In 99 00 01 02 03 04 05 06 07 08 other words, FDI has been the underpinning for

Note: Data for RO as of 2006, for BG as of 2002, for LV and LT as of financial development in the new Member

2001, for the CZ, MT and SK as of 2000.

Source: Commission services States.

( 49 ) According to Eurostat, at the end of 2005, 32.5% of all ( 48 ) For comparison, the total sum of external assets and FDI in the new Member States were concentrated in the

liabilities of the euro area stood at 218% of GDP (assets financial intermediation sector, 35.5% were realized in to GDP at 104% and liabilities to GDP at 114%) at the manufacturing, while the remaining went into services

end of 2003. (other than financial intermediation).

Chapter IV

Capital markets in an enlarged EU

This raises the question why the new Member Institutional progress has been further

States, compared with other emerging market substantiated by reforms specifically in the economies have been so successful in attracting financial sector. For instance, the average score foreign capital inflows and in particular FDI (see of the EBRD index of banking sector reform Graph IV.1.1 in chapter 4.1). reached 3.7 in 2007 on a scale from 1 to 4+. The

index measures to what extent banking laws and

2.1.3. Explaining capital flows to the new regulations comply with the Basle committee

Member States core principles on banking supervision and

whether prudential supervision is effective and The foremost explanatory factor for this success financial deepening substantial. Even though the appears to be the institutional framework that reform in the area of non-bank financial preparation for EU-accession and EU- institutions has been slower, marked progress has membership brought about. Indeed, data on the been made in that area too, with the EBRD quality of institutions reveal substantial indicator reaching the average value of 3.3 in differences between the new Member States and 2007. other economies at a similar income level.

Institutional quality is, however, not the only We refer to three indicators of institutional factor that accounts for financial inflows and the quality in order to assess the new Member States rapid development of the financial sector. At relative to a comparative set of countries (see least three additional features of the new Table IV.2.1). The "Ease of Doing Business"- Member States, most of them also related to EU indicator of the World Bank shows that the accession, are likely to have played a major role business environment in the new Member States as well. First, integration into the EU required is getting better, while in the comparative set of from the candidate countries sound countries conditions, which are already macroeconomic and structural policies that substantially worse, do not improve. Economic strengthened their fundamentals and reduced freedom has also substantially increased over the uncertainty. Second, the level of development last ten years in the new Member States, while it was sufficiently high for adopting the EU's has worsened slightly in the comparative set. institutional framework and for investors

meeting a qualified labour force. Third, Another striking difference is that the geographical proximity and trade openness institutional convergence among the new attracted foreign investors.

Member States, as shown by a decreasing dispersion between the indicator values, Obviously, higher marginal capital productivity coincides with a clear divergence in the played a core role in attracting foreign capital. comparative set, as shown by a growing However, what needs to be emphasised here is dispersion between the indicator values. While that in the new Member States the expected high the new Member States are becoming more profitability was coupled with the right homogeneous, this is not the case for the additional incentives, in terms of institutional emerging economies of the comparative set. development, political and economic certainty Confirmation of this result is given by a third and human capital. The role that preparation for indicator, the Corruption Perception Index, EU accession and EU membership played in that which reveals that corruption is becoming less of respect can not be overstated. a problem in the new Member States, while it

remains unchanged among the countries of the 2.1.4. What difference did financial comparative set. development and integration make?

Improved institutions in view of EU accession The relationship between domestic financial and the progressive adoption of the EU 'acquis development and growth, including through the communautaire' have naturally created a mobilisation of savings for capital and competitive advantage for investments from technology investments, is well established financial and non-financial companies from old theoretically and solidly founded empirically Member States. (Levine, 1997).

ropean Commission

Five years of an enlarged EU

Table IV.2.1: Quality of institutions in the new Member States and in other developing countries, 1999-2008

New Member States Other developing economies

Unweighted average Standard deviation Unweighted average Standard deviation

Rank in Ease of Doing Business (World Bank) 2006 44.4 21.1 65.3 33.1 2009 42.8 16.3 68.3 35.3

Index of Economic Freedom (Heritage Foundation) 1999 60.6 7.9 64.5 6.3 2008 66.9 5.2 63.7 8.1

Corruption Perception Index (Transparency International) 1999 4.3 1.0 4.4 1.4 2007 5.0 0.9 4.4 1.4

Note: Ease of Doing Business: the lower, the more favourable; adjusted for changes in the sample, so that data cannot only be compared between countries, but also through time; Index of Economic Freedom (between 0 and 100): the higher, the better; Corruption Perception Index (between 0 to 10): the higher, the lower corruption; "Other developing economies": 16 countries with an income level similar to that in the new Member States (Argentina, Botswana, Chile, Costa Rica, Croatia, Lebanon, Malaysia, Mauritius, Mexico, Oman, Panama, Palau, South Africa, Turkey, Uruguay and Venezuela) classified as "upper middle income by the World Bank. Source: World Bank, Heritage Foundation and Transparency International

In contrast, the connection between global Theory predicts that these benefits could be financial integration and growth seems to be less substantial (Lewis 1999). This is plausible in robust. Nevertheless, in the new Member States, light of the relatively high production the role of foreign capital inflows for high specialisation in some of the new Member States. domestic growth seems to be evident. First, they Their increased international financial assets and have allowed for total investment that has liabilities suggest that they are on track for substantially surpassed savings. Second, profiting from these advantages of financial developments in the new Member States provide integration as well. Obviously, EU enlargement strong support for the argument put forward by brought about increased diversification Kose et al. (2006) that global financial opportunities also for old Member States, as they integration has indirect beneficial effects on are now in a position to deploy their financial

growth through institutional development and means over a wider integrated economic area. policy discipline. As outlined in the previous section, advanced institutional development supported by EU accession laid the basis for 2.2. CHALLENGES OF FINANCIAL attracting sizeable capital inflows (in particular INTEGRATION AND DEVELOPMENT FDI), which in turn fostered additional institutional and policy advancement. The goal In spite of the numerous benefits of financial of attracting further foreign capital and the risk development and integration, financial catchingof delocalisation and disinvestment of already up can raise important policy challenges if established FDI has exerted similar discipline. capital inflows, current account deficits and domestic credit expand too rapidly, leading to an Specifically in the financial sector, the strong unsustainable boom and subsequent bust. Indeed, involvement of foreign banks helped to make some of the new Member States have already bank restructuring and privatization a success, exceeded related speed limits and are now faced rein in political involvement in credit decisions, with significant adjustment needs and potentially and sever incestuous relationships between banks quite protracted growth slowdowns. In addition, and enterprises – although it may occasionally the current global financial turbulences add and temporarily also have come at the cost of complexity as they have encouraged more restricted access to credit for small firms. international investors to take a closer look at stability risks and vulnerabilities in emerging Indirect benefits of global financial integration economies like the new Member States. This on growth and economic welfare also result from underscores the importance of strong domestic new opportunities for portfolio, risk and income policies that ensure sound fundamentals as the diversification and consumption smoothing (van new Member States continue their way on the Wincoop 1994; Asdrubali, Sorensen and Yosha, long road to full convergence. 1996; Garcia-Herrero and Wooldridge, 1997).

Chapter IV

Capital markets in an enlarged EU

2.2.1. Boom mechanics and bust risks 2.2.2. Vulnerability trends

In a typical boom phase, at macroeconomic The following subsections elaborate on some of level, rapid credit growth leads to a surge in the vulnerability trends observed in the new consumption and investment and widening Member States that have already led to or might current account deficits. At the same time, high suggest further unsustainable booms. capital inflows may lead to substantial real currency appreciation and relatively high

inflation to low or negative real interest rates. At Credit developments

microeconomic level, this stimulates domestic Credit to the private sector has expanded at borrowers to take on debt – including to a large double-digit rates in the new Member States over extent in foreign currency, thereby incurring the last decade, albeit from low initial levels of balance sheet risks (as their income streams and financial intermediation. It has been boosted not assets are mostly in domestic currency). In only by decreasing borrowing costs but also by addition, in boom phases, banks often tend to favourable tax treatments (e.g. for mortgage adopt a pro-cyclical lending policy, while loans and savings committed to construction). underestimating lending risks. As a result, they may loosen credit standards, thus increasing Graph IV.2.11: Loans to private sector in 2004 and 2008

credit risks for the banking sector in a downturn. Loans to house hol ds Loans to corporations

% of total l oans

There are basically two scenarios in which 100

lending booms can play out. First, in a "benign

scenario", domestic credit expansion and 80 widening current account deficits correspond 60

mostly to sound domestic investment and consumption based on realistic income 40 expectations. Self-correcting mechanisms kick in sufficiently early to rein in unsound domestic 20 credit loosening and overheating. Adjustments take place smoothly without causing major 0

disruptions for economic growth and financial 04 08 05 08 04 08 04 08 04 08 04 0804 08 05 08 04 08 04 08 04 08 04 08 development. BG C Y C Z EE HU LV LT MT PL RO SK SI

Note: Data on total loans to the private sector refers only to the non

Second, in a "non-benign" scenario, the lending financial private sector Source: ECB

boom degenerates. Fuelled by negative real interest rates and over-optimistic expectations of

companies and households about future profits In most new Member States, credit growth is and income, capital inflows and credit growth mainly the outcome of a surge in household surpass equilibrium levels. Rapid credit loans, which have grown more rapidly than expansion contributes to buoyant consumption credit to corporations over recent years. Credit to and unproductive investment, leading to real corporations still constitutes the bulk of total estate and asset price bubbles. In such a scenario, credits to the private sector, but, as a a sudden bust triggered, for instance, by an consequence, its share has steadily declined. adverse external shock may induce a disorderly With the exception of Bulgaria, Malta and unwinding of imbalances and severe problems in Slovenia, credit to households in the new the financial sector. Depending on the exchange Member States exceeded 40% of total rate regime, rapid currency depreciation may outstanding loans to the private sector in 2008 ensue (and lead to "lethal" balance sheet (Graph IV.2.11).

mismatches) or a prolonged growth crisis may occur (if a currency peg is maintained and domestic prices and wages lack sufficient flexibility).

ropean Commission

Five years of an enlarged EU

Graph IV.2.12: Loans to households by purpose in 2004 and 2008 households and non-financial corporations to

Mortgage loans C onsume r cre di t O the r purpose s foreign-currency-denominated loans over recent

100 % of total loans years (Graph IV.2.13). This has been more

pronounced in the new Member States with

80 currency board type arrangements (Baltic

countries and Bulgaria).

60

Among the countries favouring more flexible 40 exchange rate regimes, Romania and Hungary

also have a relatively high share of foreign 20 currency-denominated loans, making in

particular households more vulnerable to 0 currency depreciations, as the latter increase the

04 08 05 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 debt burden (measured in domestic currency). In BG C Y C Z EE HU LV LT MT PL RO SK SI the Czech Republic and Slovakia, foreign

Source: ECB currency loans have been mostly channelled towards the corporate sector, while household

Within credits to households, mortgage loans debt in foreign currency has remained low. have seen the most dynamic development in the post-accession period. About half of the new Graph IV.2.14: External loans of BIS reporting banks in 2004 and

Member States recorded a share of more than 2008

50% of mortgage loans in the total outstanding 100 % of GDP Vis-à-vis al l se ctors

loans to households at the end of 2008 (Graph Vis-à-vis the non-bank se ctor

IV.2.12). Mortgage loans have been increasing at 2008 (all 80 se ctors):

a particularly fast pace in Bulgaria, Romania and MT: 450%

Slovenia. Nevertheless, consumer credit still C Y: 224% 60

accounted for a relatively high share in the total credit to households in these countries. Credit for 40 other purposes (e.g. for education) stayed significantly below or around 20% of total loans 20 to households in all countries (except Cyprus).

0 Graph IV.2.13: Foreign currency denominated loans to 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08

households and corporations in 2004 and 2007 BG C Z EE HU LV LT PL RO SK SI

100 % of dome stic cre di t FX l oans to corporati ons

FX l oans to house hol ds Source: BIS

80

Credit growth in the new Member States has to a large extent been sustained by increasing cross

60 border lending. The increased competition

between the subsidiaries of foreign banks has

40 tended to lower interest margins and led these

subsidiaries to fund their lending activities by 20 borrowing from parent companies, often on a

short-term basis. They have benefited from 0 relatively easy access to funding from their

04 07 04 07 04 07 04 07 04 07 04 07 04 07 04 07 04 07 04 07 parent banks. Foreign funding to subsidiaries has BG C Z EE HU LV LT PL RO SK SI limited the effectiveness of domestic prudential

Source: National central banks and supervisory measures.

One of the distinctive features of credit In general, cross-border loans have increased expansion in the new Member States has been significantly in all new Member States during the the marked increase in the exposure of post-accession period. At the end of 2008, the

Chapter IV

Capital markets in an enlarged EU

Table IV.2.2: Financial soundness indicators for the new Member States in 2004 and 2007

CA (%) a) NPLs (%) b) MS (EUR Mio.) c) ROA (%) d) ROE (%) e) LQ (%) f) 2004 2007 2004 2007 2004 2007 2004 2007 2004 2007 2004 2007 BG 16.1 13.9 2.0 2.1 0.6 1.0 2.1 2.4 19.6 24.8 30.1 28.2 CY 11.4 12.4 11.7 7.1 4.4 8.1 0.2 0.8 4.4 14.1 - 29.5 CZ 12.6 11.5 4.1 2.6 2.2 3.5 1.3 1.3 23.3 24.5 33.6 28.6 EE 13.4 14.8 0.3 0.5 1.9 3.3 2.1 2.6 20.0 30.0 22.3 17.6 HU 12.4 10.8 2.7 2.4 1.9 2.6 2.0 1.4 25.3 18.1 21.1 16.0 LT 12.4 10.9 2.2 1.0 1.2 2.3 1.3 2.0 13.5 27.2 28.3 21.9 LV 11.7 11.1 1.1 0.4 1.2 2.4 1.7 2.0 21.4 24.2 33.7 23.9 MT 21.4 23.2 6.5 1.8 6.2 10.1 1.3 1.0 13.2 10.7 24.3 21.8 PL 15.4 11.8 9.2 3.1 0.9 1.4 1.4 1.8 17.1 23.7 26.2 21.9 RO 20.6 13.8 8.1 9.7 0.5 1.1 2.5 1.3 19.3 11.5 63.6 52.0 SK 18.7 12.4 2.6 2.5 1.6 2.5 1.2 1.1 11.9 16.6 13.3 36.5 SI 11.8 11.8 3.0 2.5 2.1 3.6 1.1 1.3 12.5 15.1 88.6 84.8

Note: CA - capital adequacy; NPLs - non-performing loans; MS - management soundness; ROA - return on assets; ROE - return on equity; LQ - liquidity; a) CY: 2005; SI: 2006; b) CY, SI: 2006; RO includes substandard, doubtful and loss loans; c) own calculations; d) CY: 2005; SI: 2006, before extraordinary items and taxes; EE: before tax; e) CY: 2005; SI: 2006, before extraordinary items and taxes; SK – without branches; f) CY and SI for 2005 (for SI, average short-term assets to average short-term liabilities); LV, RO and SK for 2006 (for SK, liquid assets include government bonds in holdings-to-maturity portfolio); EE: March 2007; CZ and PL: September 2007.

Source: IMF, ECB, National central banks and own calculations

Baltic countries and Slovenia recorded the to financial developments in the new Member highest GDP share of external loans vis-à-vis all States has increased over recent years. One of the sectors (bank and non-bank), while three of the related indicators - the foreign claims of the BIS Visegrád countries (Slovakia, Poland and the reporting banks (e.g. from Austria, Germany, Czech Republic) had the lowest levels (Graph Sweden, Italy) on the new Member States – have IV.2.14). Data on cross-border lending to the picked up significantly between 2004 and 2008 non-banking sector as a percentage of GDP (Graph IV.2.15). Austria, Germany, France and highlights the fact that the corporate sector in the Italy have higher exposures vis-à-vis the new Member States has attracted a relatively Visegrád countries and Romania while the small fraction of cross-border loans. Cross Swedish banking sector may be vulnerable to border lending to the non-banking sector developments in the Baltic countries. expanded most rapidly in the Baltic countries,

Bulgaria, Cyprus, Slovakia and Slovenia

between 2004 and 2008. Banking sector trends

These credit trends and the dependence on Graph IV.2.15: Claims of selected old Member States on new foreign, often short-term financing from parent

Member States, 2004-2008 banks could have major implications for the

60

% of GDP financial soundness of the banking sector.

Standard financial soundness indicators need to be read with extreme caution, as they are lagging

40 or coincident indicators and are only available

with considerable delay. Looking ahead, a significant deterioration in connection with the

20 on-going global and regional economic slowdown cannot be excluded. The crucial question remains then to what extent parent banks will change their funding policies vis-à-vis

0

04 07 08 04 07 08 04 07 08 04 07 08 04 07 08 04 07 08 their subsidiaries in the new Member States,

AT BE DE FR IT SE leading to tighter credit conditions. This question

also underscores the importance of cross-border

Source: BIS policy co-operation, including home-host

supervisory cooperation. Mirroring the importance of cross-border lending, the exposure of some old Member States

ropean Commission

Five years of an enlarged EU

In a nutshell, available financial soundness rated credit institutions (see Table IV.2.3). indicators suggest the following trends (Table Cyprus, Malta, Poland, Slovakia and Slovenia IV.2.2). Capital adequacy (regulatory capital to have a moderately strong banking system, while risk-weighted assets) declined in all new the Czech Republic would appear to be the only Member States except for Cyprus, Estonia and country, which currently has a high banking Malta between 2004 and 2007, but still remained sector strength. The macro-prudential risks have above the regulatory threshold of 8%. Asset widened or remained constant for almost all new

quality improved as the ratio of non-performing Member States in 2008 compared to 2005. loans to total loans decreased in all new Member States except for Bulgaria, Estonia and Romania.

The ratio of total assets to the number of Current account deficits

employees, which is a good proxy for One specific macroeconomic risk that is often management soundness in the banking sector, highlighted, are the current account deficits of improved between 2004 and 2007, but the the new Member States, or more precisely their amount of assets managed by one bank employee net borrowing from abroad. Indeed, over recent is still much lower than in the euro area. years, buoyant economic growth and credit expansion have often been associated with Table IV.2.3: Fitch approach on banking system soundness for increasing net borrowing, raising concerns about

the new Member States in 2005 and 2008 its sustainability.

2005 2008

MPI 1 MPI 2 MPI 3 MPI 1 MPI 2 MPI 3

Graph IV.2.16: Private savings/investment balance and net "B" - EE - - CZ - lending/borrowing in 2004 and 2008

"C" CZ, MT, SI - - - CY, MT, PL, SK

SI 5

CY, PL, RO, BG, EE, LT, % of GDP

Private savings/i nve stme nt balance

"D" Ne t l e ndi ng/borrowi ng SK BG, LT, LV HU HU LV RO Note: Intrinsic bank system risks range from A (very high quality) to 0

E (very low quality), with all new Member States fitting in "B", "C"

or "D"; MPI (macro-prudential indicator) indicates the vulnerability -5

of the banking system to adverse macroeconomic shocks on a scale from 1(low) to 3 (high). -10 Source: Fitch Ratings -15

Return on assets improved or maintained the -20 same level between 2004 and 2007 (except in

Hungary, Malta and Romania). Return on equity -25 remained at healthy levels in all new Member -30

States, but displayed a declining pattern in 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 Hungary, Malta and Romania over the same BG C Y C Z EE HU LV LT MT PL RO SK SI period. The liquidity ratio (liquid assets to total Source: Commission services assets), which indicates the ability of the banking

sector to withstand shocks to cash flows, Between 2004 and 2008, these increases were followed a declining trend in all new Member mostly or at least partly the result of deteriorating States except Slovakia (Table IV.2.2). savings-investment balances in the private sector

(Graph IV.2.16), reflecting a shortage of

This picture can be complemented by looking at domestic private savings compared to private the intrinsic systemic risk and the vulnerability investment. This may be less of a concern as of the banking sector to macroeconomic shocks, long as it is the result of investments that using other approaches, e.g. the Fitch approach enhance the economy's international for analysing bank soundness. competitiveness and as long as the net borrowing

unfolds through stable channels, in particular

According to this approach, six new Member FDI.

States (Bulgaria, Estonia, Hungary, Lithuania, Latvia and Romania) have a low strength of the banking system as of October 2008, as the majority of banking system assets are with low

Chapter IV

Capital markets in an enlarged EU

Graph IV.2.17: Private consumption and private investment in efficient, due to the limited capacity to influence

2004 and 2008 lending and retail rates through a change in

80 % of GDP Pri vate consumpti on Private i nve stme nt policy rates. The new Member States with more flexible exchange rates are in principle better equipped to counteract the increase in foreign

60 currency-denominated loans as well as the

tendency to borrow directly from abroad. By

40 increasing exchange rate flexibility, narrowing

interest rate differentials, and implementing appropriate supervisory measures, they could

20 help reduce the incentives for foreign- currencydenominated bank lending.

0

04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 04 08 In all new Member States, fiscal policy can

BG C Y C Z EE HU LV LT MT PL RO SK SI significantly contribute to maintaining

macroeconomic and financial stability by

Source: Commission services counteracting expansionary pressures stemming

from a booming private sector. Fiscal policy

Except for the Czech Republic, Estonia, Hungary should in particular aim to avoid pro-cyclicality and Latvia private investment (as % of GDP) in the boom phase, potentially going beyond the increased in all new Member States in 2008 stricto sensu requirements of the Stability and compared to 2004. In 2008, private investment Growth Pact. It should also avoid overestimating exceeded 25% of GDP in Bulgaria, Estonia, structural trends in revenues or potential growth. Romania and Slovenia (Graph IV.2.17). On the Prudence is also needed with policies that other hand, private consumption (as % of GDP) stimulate certain types of loans – such as the tax decreased in all new Member States, except for deductibility of mortgage interest payments, Cyprus, Latvia and Lithuania in 2008 compared which could contribute to a housing boom.

to 2004. This, however, does not automatically

imply that all private investment was productive. Structural policies that improve product and

On the contrary, it has in some cases, for labour market flexibility play a paramount role instance, caused an unsustainable housing boom. for resource allocation and for smooth

adjustment after a boom phase. This is 2.2.3. Policy responses to current and particularly relevant for countries that opted for

potential challenges currency boards/hard pegs as is currently demonstrated in the Baltic countries.

Against the backdrop of these vulnerability

trends, the global financial turbulences have Prudential and supervisory measures constitute turned the spotlight on the stability risks and an important toolkit for policymakers when vulnerabilities associated with the financial confronted with rapid credit growth. At the same catching-up in emerging markets. They have thus time, prudential measures can contain the underscored the importance of strong domestic deterioration of asset quality and keep potential policies that help prevent excessive credit growth systemic risks under control. Specific measures and current account deficits and ensure sound include: higher capital requirements; tighter fundamentals. collateral needs and eligibility for certain types

of loans (e.g. foreign-exchange-denominated and

The available economic policies are different mortgage loans); stricter rules on credit across new Member States. Countries favouring concentration (e.g. limits against large exposures currency boards/hard pegs or countries that have to a single borrower); closer monitoring and already adopted the euro can no longer use assessment of loan procedures; and more monetary or exchange rate policy to cope with frequent on-site inspections targeting credit rapid credit expansion. Moreover, in countries institutions of systemic importance.

with a high degree of de facto euroisation, monetary policy transmission becomes less

ropean Commission

Five years of an enlarged EU

In addition, the exceptional and extraordinary global financial turbulences that we have been facing since 2007 have led to specific stability risks – in both the home and host countries – associated with the high presence of foreignowned banks in the new Member States. The containment of these risks requires strengthened national and cross-border policies, including enhanced home-host supervisory co-operation.

For the host supervisors in the new Member States, an enhanced information exchange on the financial performance of parent banks is of major relevance due to the fact that foreign subsidiaries are players of systemic importance in their banking sectors, while being almost immaterial from the perspective of some parent groups. However, as several parent banks in some of the old EU Member States (i.e. Sweden, Austria, Italy) are increasingly exposed to the new Member States as a whole, an improved exchange of information becomes of utmost importance for home country supervisors as well. More generally, recent events have amply demonstrated the importance of EU-wide and international cooperation for supporting national policies for macroeconomic and financial sector stability.

In all these policy areas, the relevant EU frameworks (including the Stability and Growth Pact and the Lisbon Agenda) constitute major catalysts for sound domestic policies – as the accession framework did before. It is up to the new Member States to decide to what extent they use these levers for continuing their convergence success story.

Chapter V

The free movement of labour in an enlarged

EU

SUMMARY OF MAIN FINDINGS

A major uncertainty surrounding the May 2004 situation had changed from one of jobless growth EU enlargement process was the effect it would to one characterised by predominantly tight have on East-West migration flows, in terms of labour markets. The economic slowdown since the actual numbers moving across borders and of 2008 is, however, affecting the labour market the economic impact of those flows on the with unemployment again on the rise in many sending and receiving EU Member States. new Member States.

Indeed, the free movement of workers constituted the principal change in economic Section 2 then turns to the impact of opening the integration after accession, as barriers to trade, borders and the mobility of workers. It first FDI and other capital movements had already reviews the transitional arrangements for the free been largely removed in the run-up to movement of workers that have been put in place enlargement. in Member States. It then presents the available

evidence on the extent of intra-EU mobility after The sizeable income differentials which existed 2004, identifies the main receiving and sending in the pre-enlargement period sparked concerns countries, and sketches the characteristics of the that there could be a massive surge of workers movers and the various types of mobility flows from poorer central and eastern European that can be distinguished. Based on this countries flooding into the labour markets of the descriptive evidence, the section then proceeds to old Member States and impacting negatively on assess the economic impact of the mobility flows the wages and employment prospects of local following enlargement for both the sending and workers. These fears led to many old Member receiving countries. It finds that migration States imposing temporary restrictions on the induced re-allocation of labour resources across flow of new Member States' workers into their countries following the 2004 EU enlargement countries, with just three Member States (the process has already brought sizeable economic UK, Ireland and Sweden) fully opening their benefits for the enlarged EU. Moreover, in line labour markets in May 2004. In the new Member with other studies and the recent Communication States, however, the predominant perception was from the European Commission on the impact of initially that the availability of "surplus" labour the free movement of workers in the context of should ensure that they gained from declines in EU enlargement, it can be concluded that postunemployment and from an influx of emigrants' enlargement intra-EU mobility flows have not remittances, with the migrants themselves led - and are unlikely to lead - to serious labour benefitting strongly either as a result of moving market disturbances, with respect to both real out of unemployment or from finding a better wages and unemployment trends. remunerated job; only more recently, with tightening labour markets, emerging skill shortages and associated inflationary pressures, have concerns grown that the outflow of workers might be accentuating labour market imbalances and hampering growth prospects.

Against this backdrop, this chapter examines the reality regarding intra-EU cross-border mobility flows over recent years and assesses whether the initial economic predictions have been confirmed or confounded by actual events. The first section sets the stage for the analysis documenting the broad improvement in labour market patterns in the enlarged EU over the period 2004-2007.

Indeed, by 2007 unemployment in the old

Member States had fallen to its lowest level in many decades, with both cyclical and structural factors contributing to the favourable developments; in the new Member States, the

• 1. 

  CHANGING LABOUR MARKET PATTERNS IN THE

  ENLARGED EUROPEAN UNION

Before the global financial crisis started to hit Remarkably, the fall in the unemployment rate employment, the overall performance of EU was associated with an increase in both the labour markets had improved significantly since employment and the participation rates (Graph 2003. Aided by stronger economic activity, V.1.2). Employment growth was particularly employment creation picked up significantly buoyant, owing to an increase in the job content from the modest rates recorded in the years that of growth. Accordingly, from 1995 to 2007 followed the 2001 slowdown. Between 2004 and employment and participation rates in the old 2007, net job creation in the EU-27 amounted to Member States rose respectively by about 7 and 12.2 million jobs, compared to 2.2 million new 5 percentage points, to 67% and 72%. While jobs over the period 2001-2004, and in 2007, the broadly-based, female and the older workers employment rate reached 65.4%. The increase in were the most dynamic components, with the employment rate, albeit from significantly increases in employment rates of more than 10 lower levels than in the old Member States, was percentage points. Although these improvements particularly pronounced in the new Member partly reflected long-term changes in socio States, where it rose from 55.9% in 2004 to economic behaviour (e.g. a different attitudeto 59.8% in 2007, but the old Member States female employment and participation) and recorded an increase in the employment rate over stronger growth playing a role as well, they are this period as well, by 2.2 percentage points to also indicative of structural reform efforts 67% in 2007. This broad based improvement was coupled with continued wage moderation having until recently also reflected in the development started to pay-off. of unemployment rates (Graph V.1.1). In 2007, the EU-27 unemployment rate dropped to 7.2%, The perception that labour market problems the lowest level for many decades, due in could be cured by people leaving the labour force particular to significantly lower unemployment led to easier access to early retirement and other in the new Member States. welfare benefits in the 1980s. Transfers from

people working to those out of the labour force The following sections of this chapter look into distorted the balance between social assistance these developments in somewhat more detail. It (i.e. assistance to those at a high risk of poverty starts with a brief review of labour market trends and social exclusion) and social security in the old Member States, before taking a closer (unemployment and welfare-related benefits), look at the improved labour market situation in blurring their relative roles. But as governments the new Member States. This sets the stage for an became more aware of the weaknesses of the analysis of worker mobility flows in the enlarged "lump of labour fallacy", they increasingly made EU in the second part of this chapter. efforts to develop activation policies explicitly

designed to influence job-search and strengthen the incentive structure of the tax and benefit

1.1. BETTER LABOUR MARKET PERFORMANCE systems.

IN THE OLD MEMBER STATES The introduction of more flexible working

By the time eight Eastern European countries arrangements, mainly achieved by easing access and two Southern European countries joined the to part-time and/or temporary work, has been EU in May 2004, significant changes had already another main component of labour market been occurring in the labour markets of the old reforms, especially in the euro area. However, Member States since the mid-1990s. After reforms of employment protection legislation having reached a peak in 1994, the have rarely addressed the excessive rigidity of unemployment rate started to move downwards provisions for regular contracts and have mainly and had, by July 2007, fallen to 6.8% (7.3% for been aimed at introducing flexibility 'at the the euro area), the lowest level for many decades. margin'. Partial labour market reforms have been

paying off in terms of higher employment growth via easier access to work for groups with

Chapter V

The free movement of labour in an enlarged EU

Graph V.1.1: Harmonised unemployment rates in the EU, 2000 and 2007

20 2007 2000

% of l abour force (ye arl y ave rage s) 18

16

14

12

10

8

6

4

2

0 NL DK C Y LT AT IE EE LU SI C Z UK LV IT SE MT RO BG FI O MSEU- HU BE PT EL ES FR DE PL SK 27

Source: Eurostat (Labour Force Survey)

low labour market attachment, according to ensuring adequate income support and recent research by the Directorate General responding to the fears and insecurities of

Economic and Financial Affairs( 50 ). Even so, European citizens.

piecemeal reforms have increased the duality of the labour market with a growing share of workers ending up in precarious jobs with 1.2. LABOUR MARKETS IN THE NEW MEMBER limited opportunity to progress to more stable STATES

employment and better pay( 51 ). Thus, despite

having until recently gone hand-in-hand with Jobless growth initially strong employment growth, increased labour market segmentation has contributed to growing At the early stages of the transition to market job instability and rising wage differentials. economies, over-employment in the state sector

and labour hoarding were common, which gave Consequently, in its Communication on rise to high levels of participation and high levels flexicurity, the Commission (2007f) stressed the of disguised unemployment, low productivity importance of labour market reforms shifting the and low wages. Adjustment requirements were focus from security on the job to security of immense when the market was opened to being in employment, backed with effective competitive pressures and extensive restructuring insurance tools against the risk of job loss. These of the economies started (e.g. Boeri, 2000 and reforms would enable workers to move smoothly Svejnar, 2002). However, the output recovery from declining to expanding activities, thus after the initial “transition shock” of the early easing tensions in the adjustment process, while 1990s was accompanied by continued job

destruction, and when the Central and Eastern European Countries had to face the Russian crisis in 1998 and the global economic slowdown

( 50 ) For econometric evidence see European Commission

(2008h); for a discussion of the effects of euro-area in 2001-2002, labour markets took a new

participation on the reform path see European adjustment hit.

Commission (2007f). The effect of reforms improving

the employability of groups with low labour market Thus, while the average growth rate of the new

attachment on the employment and productivity trade-off

is discussed and assessed in European Commission Member States exceeded that of the old Member

(2007e). States since 1995, employment continued to fall ( 51 ) In the case of Italy, Rosolia and Torrini (2007) found that or not grow at all. Until 2003, job destruction in

the wage gap between old and young workers went up

from 20% in the late 80s to 35% in the early 2000s… manufacturing prevailed in almost all countries.

this decay is not accounted for by developments in Between 1995 and 2003, employment in industry

relative supplies of skill-age groups over time and (excl. construction) fell at an average annual rate

reflects almost entirely falling entry wages."

European Commission

Five years of an enlarged EU

of about 1.8% against an average fall of 0.3% for The changes in the unemployment rate do not the old Member States. The jobs created in reflect uniform patterns in the employment and services only partially offset the effect of the participation rates. The increase in downsizing of manufacturing industry and the unemployment in Poland and Lithuania was employment losses in agriculture and mining. accompanied by massive job losses, especially in Overall, in 2003 employment was 6% lower than Poland, and by a gradual but continuous decline in 1995, corresponding to a loss of 2.5 million in the participation rate, which was also common jobs. Compared to the old Member States, output to the Czech Republic and Slovakia. Conversely, growth in the new Member States translated into the participation rate remained broadly high productivity growth - growth was jobless unchanged in Estonia and Malta and even (Graph V.1.3). increased over time in Cyprus, Hungary, Slovenia and Latvia. Despite all the progress in Graph V.1.2: Employment and GDP growth recent years, employment and participation rates 170 1995 = 100 of the Member States that joined in 2004 were in

GDP O MS 2007 below the EU-15 average (67% and 72%) 160 by about 7 and 6 percentage points (Graph

Empl oyme nt O MS

150 V.1.4).

GDP NMS

140

Empl oyme nt NMS Male workers were hit more adversely than 130 women, which can be explained by restructuring

taking place in sectors, such as industry or

120 mining, largely dominated by men. The high

110 share of employed persons in agriculture and the

100 baby boomers of the post-war years, hit hardest

by the shocks, made the fall in the total 90 employment and participation rates more

95 96 97 98 99 00 01 02 03 04 05 06 07 spectacular and persistent. By 2007, male

Source: Commission services employment rates were below the level of 1998 by about 6 percentage points. In contrast, the

Although all countries of the area were hit by the female rates, consistent with the overall pattern same shocks, the response of the labour market of the old Member States, picked up in almost all

differed across countries, gender and age groups. new Member States. The impact on unemployment was particularly profound in Poland, Slovak Republic, and For the new Member States as a whole that Lithuania, where the gap vis-a-vis the EU-15 joined in 2004, the youth employment rate (for unemployment stood at more than 10 percentage those aged between 15 and 24) has been points in the peak year of unemployment. declining since the early years of transition and Conversely, the increase in unemployment was in 2007 stood at about 27%, more than 13 more contained in the others countries (Graph percentage points below the EU-15 average. This V.1.4). Yet, with the exception of Hungary, decline was particularly sizeable in the Czech Latvia, Slovenia and the South Mediterranean Republic, Hungary, (13 percentage points below countries, the increase in unemployment respectively compared to 1998), Lithuania and persisted for a considerable period of time. It Slovakia (-7 percentage points compared to the took more than 10 years for the unemployment rate of 1998). While a declining youth rate of Czech Republic, Poland and Slovakia to employment rate is evident throughout the EU, get back to the lowest rates of the mid-1990s; reflecting the general tendency towards more and, while less persistent, 5 and 7 years were education, the very low rates for the new needed for the unemployment rates of Estonia Member States signal a difficult transition from and Lithuania to recover to the low rates of the school to work, especially for those at the lower early 2000s. end of the skill scale (Quintini et al., 2007).

Chapter V

The free movement of labour in an enlarged EU

Graph V.1.3: Labour market performance in the old Member States, 1995-2007

Employment rate 11 Une m ployme nt rate 50

% of labour force

70 % of working age population

10 48

60 9 46

8 44 50

Total Older workers Female

7 NAIRU (lhs) 42

40

6 une mploym e nt rate (lhs) 40

Long te rm une m ployme nt (as %

30 of total une mployme nt, rhs) 5 38

95 96 97 98 99 00 01 02 03 04 05 06 07 95 96 97 98 99 00 01 02 03 04 05 06 07 Participation rate 1.8 Employment and wage

% of working age population growth 70 1.6 ES

7 )

-0

1.4 9 5

  IE

60 1.2 r a te g e

,

h a

n

  NL R 2 = 0.45

1.0 e n t y m g

e c FI

Total Older workers Female 0.8 p

lo e ra

a v IT

50 e m EL

0.6 u a

l

n n BE PT 0.4 (a LU

  AT FR DE SE 40 0.2 UK DK

0.0 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

30 real compensation per employee minus changes in TFP

95 96 97 98 99 00 01 02 03 04 05 06 07 (annual average change, 95-07)

Source: Commission services

The older workers employment rate (aged 55-64) with the exception of Slovakia and Poland, all picked up in almost all new Member States, new Member States that joined in 2004 have a especially in Latvia, Hungary, Lithuania, and job-finding rate higher than that of the remaining Slovakia. Only in Poland was the older workers' countries of the EU, with Hungary having the employment rate in 2007 almost 4 percentage highest probability (more than 50%). There is a points below the rate of 1998. striking difference in the risk of leaving the

labour market when unemployed. While for However, the low employment and participation Poland, the Baltic States and Slovakia this risk is rates do not necessarily mean that the labour lower than or similar to that of the average of the markets are rigid. Data on transition probabilities remaining Member States, for Hungary and for the period 2002-2006 suggest that the labour Slovenia it is twice and four times as much as the market of the new Member States as a whole is EU-15 average respectively. characterised by intense job flows. Compared to the old Member States, the new Member States Tightening labour markets have relatively high job destruction and job creation rates as well as high rates in and out of Since 2003, the new Member States have seen a the labour force (in particular from reversal of fortunes in their labour markets. unemployment to inactivity and vice versa). Aided by resilient economic growth,

employment gathered pace, with almost 3 There is a significant heterogeneity, especially as million net new jobs created over the period regards the probability of either finding a job or 2003-2007. The expansion of the workforce was of becoming inactive when unemployed. Yet broadly-based and involved all segments of the

European Commission

Five years of an enlarged EU

Graph V.1.4: Labour market performance in the new Member States, 1990-2007

20 Unemployment rates 20 Unemployment rates

18 % of labour force 18 % of labour force

16 16

14 14 CY CZ HU

12 12 MT SI OMS

10 10

8 8

6 6

4 EE LT LV 4

PL SK OMS 2 2

0 0 90 92 94 96 98 00 02 04 06 90 92 94 96 98 00 02 04 06

Employment rates Employment rates

70 70 % of working age population % of working age population

65 65

60 60 CY CZ

HU MT SI OMS

55 EE LT 55

LV PL SK OMS

50 50 90 92 94 96 98 00 02 04 06 90 92 94 96 98 00 02 04 06

75 Participation rates 75 Participation rates % of working age population % of working age population

73 73

71 71

69 69

67 67

65 65 CY CZ

HU MT 63 63 SI OMS

61 EE LT LV PL 61

59 SK OMS 59

57 57

55 55 90 92 94 96 98 00 02 04 06 90 92 94 96 98 00 02 04 06

Source:

labour force. After falling continuously in the was the vigorous acceleration of male first three years of the decade, prime-age (25-54) employment, which expanded between 2003 and and young workers' employment started a 2007 at an annual average of 2% against a yearly recovery in 2003-2004 that has accelerated in decline of 0.5% over the period 2000-2003. The recent years, achieving in 2006-2007 the highest recovery of male employment was stronger than growth rates for a decade (2% and 3% for female as men had been hardest hit by the

respectively). A salient feature of the recovery restructuring of the economy.

Chapter V

The free movement of labour in an enlarged EU

In parallel, the unemployment rate started to market has been tightening, especially in the decline, rapidly closing the gap with the rest of Baltic States, the Czech Republic, Poland, the Union. In 2007 the unemployment rate had Romania and Cyprus (Graph V.1.6). Labour dropped to 7.6%, down by 5 percentage points shortages are spread all over the economy, from its 2003 level. The decline involved all new especially in the industry sector where labour Member States and especially Poland (down by shedding was particularly pronounced during the 10 percentage points to 9.7%), Slovakia (down mid-1990s. To some extent, the appearance of by 6 percentage points to 11.1%), and Bulgaria labour shortages reflects the drop in (down by 7 percentage points to 6.9%). Even so, unemployment and average growth rates of GDP the share of long-term unemployed was on an between 2003 and 2007 above 5.5% and, upward trend and started to decline only in 2006, obviously, emigration may have accentuated still hovering at around 56% (more than 13 labour market and skill shortages. Even so, the percentage points above the EU-15 average). reported lack of personnel is a signal that

structural labour market problems are still Graph V.1.5: Overall employment rates in the new Member pending. The low employment and activity rates

States for specific groups and the high long-term

80 % of working age population

1998 2007 unemployment are an indication of the

70 difficulties faced by job-seekers in these

countries, especially young people, the low 60 skilled and the medium-skilled aged 45 years and

50 over.

40 Graph V.1.6: Employment by age and skill level

30 95 Employme nt rate in % of working age population

20 NMS (2006) high skille d

O MS (2007) 10

85 0

CY CZ EE HU LT LV MT PL SK SI NMS O MS me dium skille d

Source: Commission services O MS (2007)

75

The effects of the restructuring of the economy NMS (2006) were felt particularly by those with inflexible skills. At the onset of the transition, the general opinion was that the central and eastern 65 age bracket European countries had a relative highly 25-29 30-34 35-39 40-44 45-49 50-54 qualified labour force. The reality was an over Source: Eurostat (Labour Force Survey) expanded system of primary vocational

education which promoted the accumulation of The employment rate for the medium- and highly specific and non-fungible skills, badly adaptable skilled shows the usual hump-shaped age profile to a situation of intense restructuring. The (Graph 5.1.7). It is low for young and older inadequate skilling resulted in a high and, until workers and peaks at around the mid-40s. recently, rising long-term unemployment rate. Employment rates for the highly-skilled are not Thus, the combination of a falling far from the EU rates and are even higher for the unemployment rate and high long-term central age groups, suggesting that the highly unemployment was a symptom of skill educated were only marginally affected by the mismatch, which resulted in strong competition overall labour market shakeout. This pattern does among companies for labour and in skills not hold for the medium-skilled. Their shortages across many industries. employment rates are constantly below the EU-

The high labour shortages reported in several than in the rest of the EU after that age.

new Member States suggests that the labour

European Commission

Five years of an enlarged EU

Graph V.1.7: Job vacancy rate in the new Member States, 2005 and 2007

7 Total economy 7 Industry excluding construction

6 % of total available posts 6 % of total available posts 2005 2007

2005 2007

5 5

4 4

3 3

2 2

1 1

0 0 BG SK SI HU LV MT LT PL RO CZ EE CY OMS BG SK SI HU LV LT PL RO CZ EE CY

7 Construction 7 Whole sale and retail trade

6 % of total available posts 6 % of total available posts

5 2005 2007 5 2005 2007

4 4

3 3

2 2

1 1

0 0 BG SK SI HU LV LT PL RO CZ EE CY BG SK SI HU LV LT PL RO CZ EE CY

7 Financial intermediation 7 Public administration

% of total available posts % of total available posts

6 6

5 2005 2007 5 2005 2007

4 4

3 3

2 2

1 1

0 0 BG SK SI HU LV LT PL RO CZ EE CY BG SK SI HU LV LT PL RO CZ EE CY

Source: Eurostat

In several countries of the region, a sharp growth of compensation per employee in 2007 acceleration in nominal wage growth in line with were registered in Latvia (33.2%), Estonia tightened labour market conditions was not (26.5%), Romania (20.2%), and Bulgaria sufficiently mitigated by productivity gains, thus (17.9%). At the lower end of the spectrum, wage leading to substantial inflationary pressures growth in Malta was even below the EU-15 stemming from the labour market. Nominal figures. Half of the new Member States are compensation per employee grew stronger in the placed in between the old and the new Member new Member States over recent years and States' average values, namely, Cyprus, Slovenia,

continued to do so in 2007. The highest rates of

Chapter V

The free movement of labour in an enlarged EU

the Czech Republic, Poland, Slovakia, and

Hungary (Graph V.1.8).

The Czech Republic, Hungary, Poland, Slovakia and Slovenia, together with Cyprus and Malta exhibited most similarity with the old Member

States in terms of nominal unit labour cost growth. Although both nominal wage and productivity growth are well above the EU-15 values, nominal wage growth has been largely aligned with productivity developments. The

Baltic countries benefited from shrinking nominal unit labour costs between 1999 and

2002 owing to relatively moderate nominal wage increases and strong productivity performance.

This trend was reversed as of 2003, giving way to mounting wage pressures. Bulgaria and

Romania are also characterised by high nominal unit labour cost growth. In spite of some decline in growth rates in nominal compensation per employee, theses are still the two new Member

States with relentlessly high increases in nominal unit labour costs.

Graph V.1.8: Nominal unit labour costs and its components

25 Annual ave rage

% change (1999-2007) Labour producti vi ty (inve rte d)

20 C ompe nsati on pe r e mpl oye e

15 Nomi nal ULC

10

5

0

-5

-10 O MS C Y,MT BG,RO EE,LV,LT C Z,HU, NMS PL,SI,SK

Source: Commission services (AMECO)

• 2. 

  THE OPENING OF THE BORDERS AND MOBILITY

One of the big unknowns for policy makers 2.1. TRANSITIONAL ARRANGEMENTS FOR surrounding the May 2004 EU enlargement was THE FREE MOVEMENT OF WORKERS the effect it would have on East-West migration flows, both in terms of the actual numbers In order to address concerns about potential moving across borders as well as the economic labour market disruptions, transitional impact of those flows on the sending and arrangements were introduced, allowing Member receiving Member States. Many commentators States to restrict the free movement of workers feared that there could be a massive surge of from most of the new Member States for a workers from poorer Central and Eastern maximum of seven years after accession to the European countries flooding the labour markets EU. Concerning the eight Central and Eastern of the old Member States and negatively European countries which joined the EU in May affecting wages and local workers’ employment 2004, four of the old EU Member States in the receiving countries. These fears led to currently maintain restrictions (Table V.2.1). A many old Member States imposing temporary further extension of these restrictions after April restrictions on the flow of workers into their 2009 and until April 2011 at the latest is only countries, with just three Member States (i.e. the possible if there is a serious disturbance of the UK, Ireland and Sweden) fully opening their labour market or threat thereof (Box V.2.1). labour markets in May 2004.

With respect to Bulgaria and Romania, 11 Against this backdrop, this section examines the Member States opened their labour markets to reality regarding intra-EU cross-border mobility Bulgarian and Romanian workers upon both flows over recent years and assesses whether the countries' accession in January 2007. Greece, initial economic predictions, including those of Hungary, Portugal and Spain opened their labour standard migration models, have been confirmed markets in January 2009. or confounded by actual events. It first reviews the transitional arrangements for the free movement of workers that have been put in place 2.2. EXTENT OF INTRA-EU MOBILITY AFTER in Member States. It then presents the available ENLARGEMENT evidence on the extent of intra-EU mobility after

2004 and identifies the main receiving and 2.2.1. EU citizens resident in other EU Member sending countries. Moreover, it sketches the States

characteristics of the movers and the various types of mobility flows that can be distinguished. The exact scale of post-enlargement mobility Based on this descriptive evidence, the section flows is difficult to determine due to several then proceeds to assess the economic impact of shortcomings in the existing data and largely the mobility flows following enlargement for open borders between the Member States. both the sending and receiving countries. It finds However, available population statistics and data that the migration-induced re-allocation of labour from the EU Labour Force Survey suggest that resources across countries following the 2004 the total number of citizens from the 2004- EU enlargement process has already brought accession countries living in one of the old sizeable economic benefits for the enlarged EU. Member States has increased by some 1.1

Moreover, in line with other studies (see e.g. million since the 2004 enlargement ( 52 ).While the

Brücker, 2009, and Kahanec and Zimmermann number of citizens from the new Member States 2009) and the recent Communication from the that joined in 2004 resident in the old Member

European Commission on the impact of the free movement of workers in the context of EU enlargement, it can be concluded that postenlargement

 intra-EU mobility flows have not ( 52 ) Note that mobility flows from Malta to other EU

led - and are unlikely to lead - to serious labour Member States have been marginal. Recent outflows from Cyprus have also been rather small (amounting to

market disturbances, with respect to both real only 2% of recent overall flows from the 2004-accession wages and unemployment trends. countries to the old Member States). Greece and the UK

were the two noteworthy EU destination countries for Cypriots.

Chapter V

The free movement of labour in an enlarged EU

Table V.2.1: Member States' policies towards workers from the new Member States

OMS/NMS (excluding BG, RO, CY, MT) Bulgaria and Romania

Belgium Restrictions with simplifications Restrictions with simplifications

Denmark Restrictions with simplifications Restrictions with simplifications

Germany Restrictions with simplifications * Restrictions with simplifications *

Ireland Free access (1 May 2004) Restrictions

s Greece Free access (1 May 2006) Free Access (1 January 2009)

te

ta Spain Free access (1 May 2006) Free Access (1 January 2009)

 S France Free access (1 July 2008) Restrictions with simplifications

b er Italy Free access (27 July 2006) Restrictions with simplifications

e m

 M Luxembourg Free access (1 November 2007) Restrictions with simplifications

ld

O Netherlands Free access (1 May 2007) Restrictions

Austria Restrictions with simplifications* Restrictions with simplifications*

Portugal Free access (1 May 2006) Free Access (1 January 2009)

Finland Free access (1 May 2006) Free access (1 January 2007)

Sweden Free access (1 May 2004) Free access (1 January 2007)

United Kingdom Free access, mandatory monitoring Restrictions

Czech Republic No reciprocal measures Free access (1 January 2007)

Estonia No reciprocal measures Free access (1 January 2007)

Cyprus - Free access (1 January 2007)

te s Latvia No reciprocal measures Free access (1 January 2007)

ta

 S Lithuania No reciprocal measures Free access (1 January 2007) b er Hungary Reciprocal measures (simplifications 1.1.08) Free access (1 January 2009)

em Malta - Restrictions

 M Poland No reciprocal measures (17 January 2007) Free access (1 January 2007)

N e

w Slovenia No reciprocal measures (25 May 2006) Free access (1 January 2007)

Slovakia No reciprocal measures Free access (1 January 2007)

Bulgaria No reciprocal measures -

Romania No reciprocal measures -

Note: Restrictions also on the posting of workers in certain sectors

Source: Directorate General of Employment

States stood at over 900,000 at the end of 2003, it Graph V.2.1: Nationality of recent intra-EU movers, 2007 now stands at about 2 million. The number of % of al l re ce nt i ntra-EU move rs

Romanians and Bulgarians resident in the old RO 19% DE

Member States increased from around 690 000 in 7% UK

2003 to about 1.8 million in 2007 according to 6% PL the available data, - a process which had started FR 25% 5%

well before the accession of both countries to the

EU in January 2007 (European Commission, PT BG 4%

2008f). In terms of recent arrivals (Graph V.2.1),

Polish citizens accounted for 25% of all recent IT

SK 4%

O the r EU LT 4% 4%

intra-EU movers who took residence in another ci ti z e ns 4% 18%

Member State over the past four years, followed by Romanians (19%), Germans (7%), British Note: Recent movers defined as persons resident four years or less in

(6%) and French (5%). the host country (age group 15-64) Source: Eurostat (Labour Force Survey)

The main EU destination country in absolute terms has been the UK which received almost a

European Commission

Five years of an enlarged EU

Box V.2.1: The principle of free movement of workers and transitional arrangements

Free movement of persons is one of the The overall transitional period of a maximum of fundamental freedoms guaranteed by EU law. It seven years is divided into three distinct phases includes the right of EU nationals to freely move ("2-plus-3-plus-2" formula). Different conditions to another EU Member State to take up apply during each phase: employment and reside there with their family members. Free movement of workers (Article 39 - for an initial 2 year period, the national law of EC) must be legally distinguished from freedom the other Member States regulates the access of of establishment of self-employed (Article 43 workers from the new Member States. At the end EC) and freedom to provide services (Article 49 of this first phase, the Commission has to provide EC). The Directive on posting of workers relates a report as a basis for the Council to examine the to the latter freedom and is not subject to functioning of this first phase of the transitional transitional arrangements although Germany and arrangements (European Commission, 2006b). Austria are allowed to apply restrictions on the cross-border provisions of services in certain - Member States can extend their national sensitive sectors involving the temporary posting measures for a second phase of another 3 years of workers as set out in paragraph 13 of the upon notification to the Commission before the transitional arrangements of the country-specific end of the first phase, otherwise EC law granting annexes of the 2003 and the 2005 Acts of free movement of workers applies. Accession. Free movement of workers precludes Member States from directly or indirectly - Restrictions should in principle end with the discriminating against EU workers and their second phase but a Member State can maintain families on the basis of nationality in restrictions for a final third phase of 2 more years employment related matters. It also ensures equal upon notifying the Commission of a serious treatment as regards public housing, tax disturbance of its labour market or a threat of advantages and social advantages. such a disturbance.

However, the Accession Treaties of 2003 and The transitional arrangements for Bulgaria and 2005 allow Member States to temporarily restrict Romania will irrevocably end on 31 December the free movement of workers from the Member 2013 and for the other new Member States on 30

States that joined in 2004 (with the exception of April 2011 ( 1 ).

Malta and Cyprus) and 2007 to their labour markets. These so-called transitional arrangements can only be applied to workers but not to self-employed or any other category of EU ( 1 ) More information on transitional arrangements: citizens. Notwithstanding the restrictions, a http://ec.europa.eu/social/main.jsp?catId=466&langI

Member State must always give preference to d=en

workers from the new Member States over workers who are nationals of non-EU countries as regards access to the labour market.

third of recent intra-EU movers, followed by exceeding 2% of the total. For recent movers Spain (18%) and Ireland (10%). Around 60% of from Bulgaria, the second main receiving the Poles went to the UK, while their second country in the EU has been Germany (15%), main destination country was Ireland (Table with Greece, Italy, France, the UK and Cyprus V.2.2). Spain received well over 50% of recent receiving most of the others in largely equal

intra-EU movers from both Bulgaria and parts. Romania. The second most important receiving country for recent movers from Romania has In almost all Member States the number of recent been Italy (around 25%), with flows to other arrivals from non-EU countries exceeds the Member States much smaller and nowhere number of newcomers from other EU Member

Chapter V

The free movement of labour in an enlarged EU

Table V.2.2: Main EU destination countries of recent intra-EU other Member States the population share of movers, 2007 recent arrivals from the 2004-accession countries

Citizenship Destination (% of citizenship total) is very small, - even in Sweden which never PL UK 59 IE 17 DE 11 applied restrictions to the free movement of RO ES 57 IT 26 UK 2 workers as well as in those Member States which DE FR 33 AT 22 UK 18 have opened their labour markets since 2006.

UK FR 39 ES 20 IE 18

FR UK 35 DE 16 BE 16 Concerning recently arrived nationals from PT ES 31 FR 28 UK 28 Romania and Bulgaria, Spain and Italy show the BG ES 56 DE 15 EL 7 highest shares, with 0.9% and 0.3% respectively SK UK 55 CZ 21 IE 11 of their working-age population consisting of IT ES 26 UK 23 FR 21 mostly Romanians (note also Cyprus with 0.9%).

LT UK 52 IE 33 DE 10

Other UK 38 DE 17 FR 9

Total UK 32 ES 18 IE 10 2.2.2. Mobility flows from the sending Note: Recent movers, see graph V.2.1 countries' perspective

Source: Eurostat (Labour Force Survey)

A look at the sending countries also reveals a

States. The only exceptions are Ireland and very heterogeneous picture, with "high-mobility"

Luxembourg. Moreover, in most Member States and "low-mobility" countries amongst the new the inflow of other EU-15 nationals has been Member States.

larger than the number of recent arrivals from the

new Member States (Graph V.2.2). The highest recent mobility rate of all Member States (Graph V.2.13) is found in Lithuania, with

Ireland has also been by far the largest receiving 3.1 % of Lithuanians having moved to other EU country for nationals from the 2004-accession Member States over the past four years, followed countries relative to its population size, with by Cyprus (3%), Poland and Slovakia (both 2%). around 5% of its current working-age population Although still substantial, intra-EU mobility rates from the new Member States that joined in 2004, for Latvia and Estonia are significantly lower.

followed by the UK (1.2%). Interestingly, Portugal also has a high recent intra-EU mobility rate of 1.2 %, to some lesser

extent also Ireland and the Netherlands.

Graph V.2.2: Recent intra and extra EU movers and the resident population

9 % of working On the other hand, the Czech Republic and

age popul ati on Hungary have rather low intra-EU mobility rates

8 which are below or equal to that of many of the 7 Non-EU-27 ci tiz e ns EU-15 Member States. For Slovenia, Malta and

BG, RO

6 Luxembourg the numbers involved are too small

Ne w Me mbe r State s to be statistically reliable.

5 e xcl . BG, RO

O l d Me mbe r State s

4 As for Romania, the recent outflow of citizens to

3 other EU Member States over the past four years

amounts to about 2.5% of the Romanian working

2 age population. In Bulgaria the corresponding

1 intra-EU mobility rate has been 1.7%.

0

IE E I C Y L U E S K T U A B E S E F R IT K L D E P T D L N Z C F I U H S Taking a longer-term perspective and including

Note: Recent movers, see graph V.2.1 emigrants who left their home country more than

Source: Eurostat (Labour Force Survey) four years ago, Portugal and Ireland show the highest share of citizens living in another EU

Austria and Luxembourg also have a significant Member State (9% and 8.2% respectively, proportion of arrivals from these countries, albeit Graph V.2.3).

much smaller than in the UK and Ireland. In all

European Commission

Five years of an enlarged EU

Graph V.2.3: Mobility rates by sending country, 2007 additional inflow of workers from these Member 9 States.

% of

8 worki ng age More than 4 ye ars

popul ti on Graph V.2.4: Inflow of workers from the new Member States to

7 4 ye ars and l e ss the UK

6 70 thousand pe rsons PL SK LT C Z, EE, C Y, LV, HU, SI

5 60

4 50

3 40

2 30

1

0 20

L T E K U T C Y O R P L S K B G L V P T E

E IE L

N Z C B D H A E L S E K E

U D F

R F I IT E S

10

Note: Figures do not include citizens who were born in another Member State and continue living there 0 Source: Eurostat (Labour Force Survey) q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3

2004 2005 2006 2007 2008

2.2.3. Temporary mobility flows and postings Note: Approved applicants to the workers registration scheme

Source: UK Home Office (Accession Monitoring Reports)

A characteristic feature of post-enlargement mobility flows (and recent intra-EU mobility in Even in the case of Bulgaria and Romania, large general) is that a large part of it appears to be numbers have already been moving from these temporary. Evidence from some Member States countries and working in the EU over the past indicates that many mobile workers go to another years, suggesting that many of those who wanted Member State for a few months or years but do to move have already moved and that the not intend to stay forever. For example, data for potential for additional emigration is limited. the UK suggest that around half of those citizens from 2004-accession countries who came to Moreover, as shown in the first part of this work in the UK since 2004 may have already left chapter, all of the main EU sending countries the country again, with a similar picture have seen a rapid rise in incomes and decline in emerging for Ireland (European Commission, unemployment over recent years. There is some 2008f and Pollard et al., 2008). evidence that this is already dampening the incentive to migrate and is likely to contribute to

2.2.4. Future mobility flows a further decline in labour supply from the new

Member States (Barthélemy and Maurel, 2009). A further surge of labour mobility from the new Moreover, due to a substantially shrinking young Member States seems unlikely. Mobility flows generation, the pool of potentially mobile from the 2004-accession countries to the UK and workers from the new Member States is getting Ireland appear to have peaked in 2006 and have considerably smaller and likely to act as a brake significantly declined in 2007 and even more so on geographic labour mobility within the EU. in the first three quarters of 2008 (Graphs V.2.4 and V.2.5). Moreover, there are indications of an In addition, examples such as Sweden, Finland, increased return migration of those who are Greece, Portugal (early free labour market access already living in the UK (Pollard et al., 2008). but low labour inflows) and Germany and Furthermore, the opening of labour markets for Austria (restricted access but relatively high workers from the 2004-accession countries in inflows) suggest that restrictions on labour most of the other EU-15 countries since 2006 market access have only a limited influence on may have led to a limited diversion of mobility the distribution of intra-EU mobility. Ultimately, flows to some other Member States, but the most mobility flows are driven by other factors such as recent development of foreign population shares general labour demand, network effects through suggests that it has not unleashed a substantial existing foreign populations or language. If

Chapter V

The free movement of labour in an enlarged EU

anything, restrictions on labour market access 2.3. MAIN CHARACTERISTICS OF INTRA-EU will only delay labour market adjustments. They MOVERS may even exacerbate resort to undeclared labour,

leading to undesired social consequences both 2.3.1. Labour market status, age and gender

for undeclared workers and the regular labour force, if not accompanied by appropriate The great majority of recent movers from the enforcement of legislation (see in this context new Member States have come to work (Graph European Commission, 2008c: Communication V.2.6). Data for 2007 indicate that the average on undeclared work). employment rate of recent intra-EU movers from

the 2004-accession countries is significantly

Graph V.2.5: Inflow of workers from the new Member States to higher than for the EU-15 population ( 51 ). Recent

Ireland arrivals from Bulgaria and Romania have an

45 thousand average employment rate which is about equal to pe rsons PL LT LV SK C Z, EE, C Y, HU, SI

40 the average employment rate in the old Member

35 States and substantially higher than the overall

employment rate in Romania and Bulgaria.

30 Average unemployment among recent movers

25 from the new Member States was only slightly 20 higher than the EU-15 average, and lower than 15 for recently arrived workers from non-EU

10 countries. The vast majority of nationals from the

new Member States who recently moved for

5 work purposes are employed workers, with less

0 than 10% being self-employed.

q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3

2004 2005 2006 2007 2008 EU mobile workers are substantially younger

Note: Number of issued Personal Public Service Numbers than the overall labour forces in the sending and

Source: Irish Department of Social and Family Affairs receiving countries. Close to 80% of recently

arrived workers from the 2004-accession countries and close to 70 % from Romania and

The experience since 2004 suggests that lifting Bulgaria are younger than 35. The gender breakrestrictions on labour market access reduces the down of recent movers from the new Member likelihood of undeclared work by citizens from States by and large corresponds to that in the the new Member States. For example, it has been labour forces of both the sending and receiving suggested that up to 40% of workers from 2004- countries; women seem on average slightly accession countries registering for the workers overrepresented in the case of recent movers registration scheme in 2004 may have already from Romania and Bulgaria.

been in the country when the UK opened its labour markets (UK Home Office, 2004).

Reports from the Netherlands indicate that the 2.3.2. Occupations, skills and sectors incidence of illegal employment of citizens from Recent arrivals from the 2004-accession 2004-accession countries working without a countries have mostly gone into manufacturing, permit decreased after the Netherlands decided to construction, hotels, restaurants, business related open its labour market in 2007 (Ministry of services and private households (Table V.2.3). Social Affairs and Employment of the Recent arrivals from Bulgaria and Romania tend Netherlands, 2007). to work predominantly in agriculture,

construction, hotels and restaurants, and as employees in private households.

Most recent arrivals from the 2004-accession countries work in jobs that tend to require intermediate skills and, above all, in low-skill jobs, with rather few employed in highly-skilled

European Commission

Five years of an enlarged EU

Graph V.2.6: Socio-economic breakdown of recent movers from new Member States to old Member States

100 % of worki ng age total O MS populati on 90 popul ation re ce nt move rs from NMS e xcl . BG, RU

80 re ce nt move rs from BG, RO

70

60

50

40

30

20

10

0 Empl . Une mpl . Inacti ve Employe e Se l f Mal e Fe mal e 15-24 25-34 35-54 55-64 Low Me di um Hi gh e mploye d

Labour marke t status Profe si onal status Ge nde r Age Educational attai nme nt

Note: Recent movers, see graph V.2.1. Data on professional status, gender, age and educational attainment refer to active population aged 15-64, data on labour market status refer to total population aged 15-64. Data for the UK on educational attainment not included in the calculation due to measurement problems. Source: Eurostat (Labour Force Survey)

occupations (Table V.2.4). The proportion of Moreover, the share of those recent arrivals from recently mobile workers from Romania and the new Member States with a medium level Bulgaria among the high-skilled occupations is education is higher than among the EU-15 labour even lower, with a relatively high number force, while the share of low-skilled recent employed in crafts and elementary jobs. arrivals from Romania and Bulgaria is about the same as for the EU-15 labour force and Overall, mobile workers from the new Member substantially lower in the case of movers from States have made a positive contribution to the the 2004-accession countries. However,

skill mix of the labour force in the old Member comparing the proportion of medium and highly States (Graph V.2.7). The share of university skilled workers from the new Member States to educated recent movers from the new Member the proportion of those working in intermediate States appears to be only moderately lower than and low-skilled jobs suggests that not all of them among the EU-15 labour force. are employed according to their skill levels.

Graph V.2.7: Educational attainment of recent movers, 2006 The share of the highly-skilled among recent

Low Skil l e d Me dium ski l l e d Hi gh ski l l e d emigrants is on average somewhat higher than

among the total labour force of their home

Total 29% 45% 26%

S countries. However, the percentage of medium

M

O skilled recent movers tends to be lower than in

Move rs 17% 41% 42% the overall labour force while the share of lowskilled

 movers is relatively higher. In general, 0 Total 11% 69% 20%

-1 these figures do not suggest a disproportionate E U

Move rs 15% 65% 20% loss of highly-skilled workers for the new

Member States; yet concerns about brain drain and labour shortages should not be dismissed too

O Total 21% 63% 16% , R easily; see section 2.4.4.

B G Move rs 30% 54% 16%

0% 20% 40% 60% 80% 100%

Note : Recent movers, see graph V.2.1 Source: Eurostat (Labour Force Survey) Chapter V

The free movement of labour in an enlarged EU

Table V.2.3: Employment by economic activity of recent movers from new to old Member States, 2007

Old Member States NMS excl. RO, BG RO, BG % of total employment by group

total movers total movers total movers

Agriculture 3.1 : 9.4 2.3 20.8 7.1

Fishing 0.1 : 0.1 : (0.1) 0.0

Mining and quarrying 0.2 : 1.2 : 1.2 :

Manufacturing 17.5 15.9 22.5 25.3 22.7 10.0

Electricity gas and water supply 0.7 : 1.5 : 2.0 :

Construction 8.3 8.4 8.3 13.2 8.0 28.4

Wholesale and retail trade 14.3 10.8 14.6 12.1 13.8 6.3

Hotels and restaurants 4.6 9.1 2.9 13.3 2.5 13.2

Transport storage and communication 6.1 6.2 7.0 7.7 5.9 (2.0)

Financial intermediation 3.3 4.8 2.3 : 1.2 :

Real estate renting and business activities 10.6 17.4 6.5 9.4 3.6 6.4

Public administration 7.4 2.7 6.5 : 5.8 :

Education 7.1 7.4 7.3 2.0 5.1 :

Health and social work 10.7 8.9 6.1 6.3 4.4 3.1

Community and personal service 4.9 4.9 3.8 4.0 2.7 (2.1)

Private households 1.3 : 0.2 2.1 0.4 19.4

Extra-territorial organisations 0.1 (1.4) (0.0) : : :

Note: Recent movers, see graph V.2.1. Employment: agriculture, construction, hotels and restaurant, may understate, due to underestimation of seasonal workers.

Source: Eurostat (Labour Force Survey)

Table V.2.4: Employment by skills of recent movers from new to old Member States, 2007

% of total employment by group total OMS EU-10 movers BG/RO movers

Legislators senior officials and managers 8.8 2.6 :

High -skilled Professionals 13.9 4.3 3.1

Technicians and associate professionals 17.4 5.2 (2.4)

Clerks 11.9 4.4 (2.0)

Service workers and shop and market sales workers 13.9 17.6 16.0

Medium-skilled Skilled agricultural and fishery workers 2.5 : 2.9

Craft and related trades workers 13.6 16.0 28.3 Plant and machine operators and assemblers 8.1 18.0 4.4

Low-skilled Elementary occupations 9.9 31.0 39.1

Note: Recent movers, see graph V.2.1

Source: Eurostat (Labour Force Survey)

expected future migration flows, the skill mix of 2.4. THE IMPACT OF RECENT INTRA-EU native versus migrant workers, speed of

MIGRATION adjustment of capital stocks and other factors (Barell et al., 2007, Brücker (2007), and D'Auria,

2.4.1. Impact on growth, GDP per capita Mc Morrow, Pichelmann, 2008).

and inflation Simulation analysis employing the EU

Several recent studies have tried to estimate the Commission's QUEST model (D'Auria, Mc impact of intra-EU migration on GDP and other Morrow and Pichelmann, 2008) shows that the macroeconomic variables after EU enlargement. effect on EU-25 GDP of recent intra-EU Most of these studies find relatively modest GDP mobility flows is substantial and positive at effects in the short run and more substantial 0.27%. This GDP effect is equivalent to a effects over the medium to long-term, although collective income gain of around €30 billion for the exact results vary significantly with the the citizens of the 25 Member States. A estimates' underlying assumptions concerning migration shock of this magnitude would

European Commission

Five years of an enlarged EU

consequently be much more potent, in economic assume that most of the changes in the terms, than for example a 1 percentage point employment rate emanate from changes in increase in the EU-25's investment to GDP ratio. participation rates, with any short-term effects on In fact, on the basis of the long-run potential the NAIRU being cancelled out over the very migration estimate of Boeri et al. (2001), internal long run (i.e. more than 20 years) once the EU-25 migration flows could produce gains physical capital stock in the countries affected which are higher than those likely to be achieved has adjusted fully to the migration flows. from the further economic integration of the EU- Moreover, whilst there are some short run public 25's goods and capital markets. finance and balance of payments effects associated with the migration shock (most These highly positive effects from international notably with respect to emigrants' remittances), migration within the EU are in keeping with the the magnitude of the effects over the longer run

view that migration increases the productive use is extremely small. of human resources within the area as a whole and, hence, add strongly to GDP. This positive Regarding the distribution of the gains between efficiency effect is shown in GDP per capita, the receiving EU-15 countries and the sending productivity and real compensation of employees 2004-accession countries, Table V.2.5 (Table V.2.5), with real wages tending to grow in summarises the differences. For the old Member line with productivity over the long run. GDP per States, migration from the 2004-accession capita is an important indicator of the effect of countries has added to its labour force growth, migration on living standards since migration not implying an increase in its long term growth only changes GDP in the receiving and sending potential. The negative GDP per capita effect countries but also their respective overall reflects the lower productivity and lower real populations. wages associated with the migration shock, with labour becoming more abundant relative to The GDP per capita gain at the EU-25 level may capital and causing a reduction in the capital initially appear surprising given the negative intensity of production in the old Member States. impact of migration on EU-15 GDP per capita. With respect to the employment rate impact, the However, important composition effects have to small positive effect for the old Member States be taken into account. Whilst the average EU-15 essentially reflects the impact of participation GDP per capita effect is negative, we must allow rate changes. for the fact that there are now roughly 1 million additional workers from the 2004-accession With respect to the effects on the sending 2004- countries in EU-15 countries who have increased accession countries, GDP declines by 2¼% their incomes substantially (according to some (Table V.2.5), but capital deepening induced estimates by 100% or more). This composition gains for real wages, productivity and GDP per effect must be taken into account at the overall capita. The higher impact on productivity and EU level where, for example, if we assume that 1 real wages compared with GDP per capita is million workers are now earning close to the EU explained by the decline in the sending countries' average, as opposed to the average of the salary employment rate relative to baseline. This levels in 2004-accession countries (i.e. an decline reflects the impact of negative wealth average per capita gain of roughly €20000), this effects on labour force participation rates in the effect alone would add close to €20 billion to EU 2004-accession countries, with lower income. participation and employment rates ensuring that the GDP per capita gains are more subdued With respect to the other labour market variables relative to productivity. focussed on in the simulation, the positive employment rate effect reflects only small With respect to nominal variables, postpositive gains for the unemployment rate in the enlargement migration has led in the old Member EU as a whole, with migrants tending to move States to a decrease in the price level of -0.42% from countries with relatively high over 10 years, corresponding to an average unemployment rates to countries where rates are yearly effect on inflation of about -0.04%. This generally lower. Furthermore, it is reasonable to reduction in inflationary pressures in the

Chapter V

The free movement of labour in an enlarged EU

Table V.2.5: Medium-term economic effects of recent intra-EU mobility flows on receiving and sending Member States

Changes in GDP GDP per capita Productivity Real Employment Public Finances / percent from Compensation of Rate Balance of

baseline Employees payments OMS 0.38 -0.12 -0.13 -0.12 0.01 Neglible

NMS -2.23 0.28 0.42 0.46 -0.14 Neglible

EU 0.27 0.27 0.27 0.28 0.04 Neglible

Note: New Member States except Bulgaria and Romania; employment rate: change in percentage

Source: D'Auria, Mc Morrow and Pichelmann, 2008

receiving countries is driven by a drop in which the migrant workers come and help to nominal wages, which decrease by -0.54%. In drive economic growth by financing investment other words, immigration into the old Member in education and start-ups of capital-intensive States is expected to raise the supply potential of businesses. the host economies to a greater degree than its effects in raising aggregate demand. These Graph V.2.8: Workers' remittances (incl. compensation of

effects work essentially the other way around in employees), 2006

the sending countries, with the rise in nominal 6 % of GDP wages as a whole being associated with a price level increase of 3.56% (which corresponds to an 5 average yearly increase in the inflation rate of the

sending countries of approximately 0.36%). 4

At the individual Member State level, the degree 3

of migration exposure of old Member States to

inflows of workers from the 2004-accession 2

countries varies quite significantly and

consequently the associated economic effects 1 differ across countries. However, the estimates 0 suggest that for the main receiving and sending O G E E S E L T E M F R L N F I U K H D U K IE D IT S E countries the impact of recent intra-EU mobility R

B L

U E E L V L T B P T P L C Z S K S I

flows on GDP and inflationary pressures has Source: World Bank, Migration Remittances Factbook 2008

been quite significant.

Remittances data suggest that they make a significant contribution to GDP in several EU

2.4.2. Impact on public finances, welfare

systems and public services Member States, in particular in Poland, the Baltic States, and above all in Romania and Bulgaria

The impact of recent migration and mobility (Graph V.2.8).

flows on public finances and the welfare state

(including its financing) appears to be negligible 2.4.4. Brain drain and labour shortages in the or positive at national level although there are sending countries variations across different functions of the

welfare state and levels of government. In a number of countries, the emigration of

Migration and mobility flows have in some cases mostly younger workers has sparked concerns created pressure on education, housing and over brain drain and labour shortages. Several health care services at the local level (for an reports indeed indicate that emigration has led to overview see European Commission, 2008). labour shortages in some countries, e.g. the

Baltic States and Poland.

2.4.3. Remittances However, in many countries labour shortages

Remittances by workers living abroad can be a have been aggravated by factors other than substantial source of income in the country from emigration, such as strong economic growth,

European Commission

Five years of an enlarged EU

relatively low labour market participation, in adjustments and even exacerbate the incidence of particular of younger and older persons, and low undeclared work. internal mobility. Moreover, labour shortages mostly affect specific sectors of the economy Concerning transitional arrangements for the (e.g. construction, hotels and restaurants) and 2004-accession countries, restrictions should in professions (e.g. health care). Furthermore, the principle end on 30 April 2009. The very few differences in the skill-mix between emigrants Member States still applying restrictions on the and the sending countries’ labour forces seem to free movement of workers can only maintain be relatively moderate, suggesting that the them beyond April 2009 if they notify the overall brain drain may be limited. There is also Commission of a significant disturbance of the evidence that enrolment rates for tertiary labour market or the threat thereof. Yet, current education in the new Member States have available evidence does not point towards serious substantially accelerated over the past years, mobility-induced labour market disturbances. which may begin to balance out the outflow of This is not to say that there are no costs involved skilled labour (European Commission, 2008f and with opening labour markets to workers from Brücker et al., 2008). outside. However, practically all the evidence at hand suggests that the benefits outweigh the

2.4.5. Social impacts costs and that any negative labour market and

economic impacts have not led or are unlikely to There is evidence of differences between the lead to serious labour market disturbances, not living conditions of newcomers and host country only at an aggregate level but also at the level of nationals including higher risks of poverty, regions, sectors or occupations. poorer educational outcome for their children, difficulties in accessing housing, health care and Regarding Bulgaria and Romania for which the other social services. Furthermore, there have second three-year transitional phase starts in been reports from some sending countries of January 2009, Member States maintaining negative impacts on family cohesion and restrictions should consider carefully whether children as a consequence of one or both parents these restrictions are still needed in the light of working abroad (Commission, 2008f). the experiences and evidence presented, and

notwithstanding the rights set out in the Treaties of Accession concerning transitional

2.5. SUMMARY AND CONCLUSIONS arrangements.

Workers from new Member States have helped Even in the unexpected case of a serious labour to meet extra demand for labour in the receiving market disturbance after labour markets open, a countries and have thus made a significant Member State thus affected can still apply for a contribution to sustained economic growth. safeguard clause provided for in the Accession Evidence at hand suggests that the impacts of Treaties under which free movement of workers post-enlargement intra-EU mobility have not led may be partially or wholly suspended within the - and are unlikely to lead - to serious labour seven-year transitional period in order to restore

market disturbances. This is not to say that there a normal situation. have been no economic and social costs. However, experience suggests that instead of If it is indeed feared that opening of labour restricting labour market access of EU nationals, markets would create ‘losers’ among the resident alternative solutions may be a better and more population, alternative solutions such as labour effective way to address these costs. market policies to bring (low-skilled) unemployed people back into work may be a Moreover, the size and direction of mobility more efficient way of dealing with this issue, at flows is not only driven by restrictions on labour the same time allowing the benefits of intra-EU market access but also by general labour supply mobility to be reaped. and demand and other factors. Restrictions on labour market access may delay labour market Likewise any negative impacts concerning public services, housing, social cohesion, and

Chapter V

The free movement of labour in an enlarged EU

exploitation of migrant workers or undeclared consisting of such elements as measures to work need to be addressed. However, such increase general labour market participation, impacts are not a good reason to maintain further improvements to education and restrictions on labour market access under vocational training, pay and working conditions transitional arrangements. On the contrary, as for public sector workers, incentives for return experience has shown, some of these problems migration, facilitating both internal labour are likely to be exacerbated by access mobility and immigration from outside the EU. restrictions, such as the incidence of undeclared work, false self-employment or the violation of Finally, it is worth remembering that freedom of labour standards. movement of workers is one of the basic

freedoms under the EC Treaty. This freedom is From the perspective of new Member States, in based on the rationale that international labour particular the ‘high-mobility’ countries, mobility contributes positively to the way labour substantial outflows of workers are sometimes markets function throughout Europe, something perceived as a mixed blessing. On the one hand, to which all Member States have subscribed. For emigration has helped to reduce unemployment many citizens throughout Europe, in particular in in some Member States by allowing unemployed the new Member States, the freedom to move persons to look for jobs in other Member States. and work in another European country has also On the other, the outflow of, in particular, become a powerful and positive symbol of what younger and relatively highly-skilled people Europe means for the individual. It is this aspect, have led to concerns about brain drain and labour too, which should not be forgotten when shortages. deciding by when to allow all EU citizens to

enjoy this freedom. While some Member States, in particular the high-mobility countries (e.g. Poland and

Lithuania), do indeed suffer from skill shortages, there are a number of factors which help to alleviate or offset these problems. First, a significant recent rise in tertiary-education enrolment indicates that the number of highly educated people available to the labour market has been increasing in most of the new Member

States. Secondly, much of the recent east-west mobility appears to be temporary. Moreover, improving income and working conditions in most of the new Member States already seem to be starting to reduce the incentive to emigrate and to attract back home many of those who are still abroad. And those who do come back often do so with improved working skills and international contacts which can be of benefit to the home country.

Brain drain, in any case, cannot be effectively curbed by legal restrictions on the free movement of workers, even if well meant. Many destinations, both inside and outside Europe, would still remain in particular for the welleducated.

Addressing brain drain and skill shortages will require policy-makers of mainly the sending countries to devise an appropriate policy mix

Chapter VI

Integrating in the EU or in the world?

SUMMARY OF MAIN FINDINGS

Against the background of increased integration manufacturing sector in real terms. of goods, labour and capital markets, as analysed Concentrating on the sectors displaying in previous chapters, the business cycle in the comparative advantages maximises catching-up, new Member States shows a higher degree of but delays the convergence of economic synchronisation with the old Member States as structures with the old Member States, compared to the global business cycle. Overall, hampering the synchronisation of business there is still a synchronisation lag between the cycles. The associated risks can, however, be new and the old Member States, but the business overcome with sufficient financial deepening and cycle in Cyprus, the Czech Republic, Malta, integration leading to risk sharing. Poland and Slovenia already displays a high degree of alignment. Greater synchronisation means less volatility and less country-specific shocks, facilitating the formulation of policies, as similar recipes can be applied throughout the

European Union.

The greater synchronisation in some countries does not appear to have been backed by higher trade intensity as such, but there is some evidence that the similarity of trade patterns mattered. Furthermore, similar monetary policy and, to a lesser extent, fiscal policy and financial integration are important factors in explaining why some Member States are better synchronised than others with the EU-15 countries.

Trade integration between the old and new

Member States levelled off, but for the EU as a whole the degree of integration was maintained on account of increased trade among the new

Member States. More importantly, increasingly homogeneous trade patterns between the two groups of countries are observed, indicative of more intra-industry trade that is expected to promote a symmetric propagation of shocks.

The message coming from the production structure of the economy is ambivalent. There is a trend towards similar economic structures in nominal terms, with the share of services in GDP growing in the new Member States from 56% of

GDP in 1995 to 63% in 2006, which is, however, still below the old Member States (72% of GDP).

Agriculture and manufacturing remain more important in the new Member States than in the old (4.6% of GDP versus 1.6% and 21.2% versus

16.7% in 2006, respectively). While rising relative prices (and wages), reflecting the

Balassa-Samuelson effect, are the drivers behind the increased importance in nominal terms of the service sector in the new Member States, strong productivity gains explain the rise of the

INTEGRATING IN THE EU OR IN THE WORLD?

Economic theory suggests that the degree of The new Member States are characterised by a cyclical synchronisation is related to the degree high and rising degree of trade openness. of economic integration and structural similarity Measured by the average of exports and imports between countries. In gauging changes in the as a percentage of GDP, openness in the EU-12 synchronisation of countries' business cycles and has increased from 42% in 1999 to 58% in 2007. the underlying driving factors, it is important to Looking specifically at new Member States' distinguish EU-specific developments from exports to EU-15 countries, the share in total worldwide integration tendencies, i.e. exports was fairly stable at around 68% between globalisation. 1999 and 2003, but has decreased since then to

just below 60% in 2007. Exports between new The effects of goods and capital market Member States have gained in importance since integration on business cycle synchronisation are 2004, with their share in total new Member theoretically ambiguous. The net effect is States' exports rising from around 14% in the composed of a synchronisation-enhancing effect pre-accession period to close to 20% in 2007. on the demand side of the economy, and a The share of exports to former USSR countries synchronisation-diminishing effect on the supply (CIS) has increased since 2004, while the rest of side resulting from increased incentives for the world has slightly lost ground as a trading specialisation. partner.

Against this background, this chapter analyses Overall, it appears that while new Member the link between economic integration of the new States' trade openness has increased over time, Member States in the EU, including an analysis the share of exports going to the old Member of structural similarity and specialisation trends States, though still high, has been falling. The (section 1), and the synchronisation of their rest of the world, including the US, does not play business cycles (section 2). Section 3 seeks to a big role. Looking at flows from the old formalise this link using an econometric model. Member States, however, the share in total

exports going to the new Member States has risen steadily over the past decade (to 7.5% in

• 1. 

  ECONOMIC INTEGRATION, STRUCTURAL 2007).

  SIMILARITY AND SPECIALISATION Structural similarity

Openness to trade is a key element in measuring the degree of integration of the new Member The similarity of economic structures has a direct States in the EU. The higher the degree of and an indirect link to cyclical synchronisation. openness, the more any changes in international The direct effect works through the symmetric prices of tradable goods are transmitted to impact of common shocks and the decreasing domestic prices and the cost of living. likelihood of idiosyncratic shocks in the case of Furthermore, as indicated by Frankel and Rose structurally homogeneous countries. The indirect (1998, 2000), a high degree of trade openness is effect operates through trade relationships, where likely to lead to more synchronous business the degree of cross-country specialisation is cycles via a symmetric propagation of common decisive for whether trade can be expected to demand shocks. Yet, as argued by Krugman foster or reduce business cycle synchronisation. (1993), this is to be expected only to the extent that trade is dominated by intra-industry trade, The composition of output tends to be closely whereas inter-industry trade would favour related to the stage of economic development. sectoral specialisation, and thus a de Empirically, a higher level of development can synchronisation of cycles. The analysis of trade be associated with a smaller share of agriculture integration in the context of cyclical in aggregate output and a larger share of synchronisation must thus be complemented by services, whereas the share of industry typically an analysis of the similarity of economic has an inverted U-shaped relationship to per structures and the quality of trade flows. capita output, increasing first and declining later.

Trade integration

Chapter VI

Integrating in the EU or in the world?

Table VI.1: Output composition in nominal terms

% of gross value added 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Agriculture OMS 2.7 2.7 2.6 2.4 2.3 2.2 2.2 2.1 2.0 1.9 1.7 1.6

NMS 8.6 8.1 7.7 6.9 6.1 5.7 6.0 5.3 5.2 5.7 4.9 4.6 Construction OMS 5.9 5.7 5.5 5.4 5.5 5.5 5.6 5.7 5.8 5.9 5.9 6.1

NMS 6.2 6.6 6.5 7.0 6.9 6.6 6.3 6.1 5.9 5.8 6.2 6.7 Manufacturing OMS 20.3 19.9 20.0 19.9 19.5 19.3 18.8 18.2 17.6 17.3 16.9 16.7

NMS 23.2 22.7 22.5 21.5 21.1 21.2 20.3 20.0 20.5 21.4 21.1 21.2 Energy OMS 3.2 3.2 3.1 2.9 2.8 2.8 2.7 2.7 2.6 2.7 2.9 3.1

NMS 5.8 5.8 5.5 5.2 5.2 4.9 4.9 5.1 5.0 5.1 4.9 4.8 Services OMS 67.9 68.4 68.8 69.2 69.9 70.1 70.6 71.4 72.0 72.2 72.5 72.4

NMS 56.1 56.8 57.8 59.4 60.8 61.5 62.5 63.5 63.5 62.0 62.9 62.8 Distance OMS-NMS 11.8 11.7 11.0 9.9 9.1 8.6 8.1 7.9 8.6 10.2 9.6 9.6

OMS-US 7.9 7.4 7.3 7.0 7.1 7.1 7.8 7.5 7.4 7.0 6.6 6.6 NMS-US 19.4 18.9 18.1 16.9 16.0 15.4 15.5 15.0 15.2 16.4 15.2 15.4

Note: The distance indicator is computed as I = 100*(|sjOMS-sjNMS|)/2, where sj denotes the share of activity j in total activity. Distance = 0 indicates identical output composition; distance = 100 indicates maximum dissimilarity in output composition.

Source: Commission services (AMECO)

Distinguishing between agriculture, construction, countries. While the distance measure declined manufacturing, energy/water and services, the steadily until around 2000, there is a stabilisation shares of the five activities in total value added thereafter.

(VA) at current prices reveal a significant difference in output composition between old To examine whether the movements as described and new Member States (Table VI.1). are due to real output redistribution, changes in Agriculture accounts for a significantly larger relative prices or both, the same measures can be share in the new Member States, and services computed on a real basis, i.e. using value added represent a much smaller share. Manufacturing data at constant (2000) prices. In principle, one and construction are somewhat larger in the new would expect both price and quantity changes to Member States, and more significantly so the occur. Productivity growth in the tradable sector energy and water sector. At the same time, while should raise the relative prices of (less traded) there are no dramatic changes in the structure of services in the new Member States via the output over the observed twelve-year period, Balassa-Samuelson effect. Changes in there is nonetheless a trend of convergence of the consumption patterns linked to an increase in new towards the old Member States. While the living standards should also drive up prices of shares of agriculture and manufacturing declined services and lower demand for agricultural between 1995 and 2006, the services sector products. At the same time, real output increased. However, since around 2003/4, these redistribution would imply real resources trends appear to have come to a halt or even been flowing from the stagnant activities to the partly reversed in the services and manufacturing growing activities, i.e. presumably services and sectors. to some extent industry.

The information can be condensed by computing In real terms, the changes in output composition an index of output dissimilarity, assessing the point to slight structural divergence rather than overall distance in sectoral output composition convergence (Table VI.2). While the real between new and old Member States (Krugman, distance index is rather stable between 1995 and 1993). The distance indicator points to a 2002, the measure points to mounting structural diminishing distance between new and old differences since around 2004. The picture is Member States between 1995 and 2002, but to a again similar for the US, but slightly less renewed pick-up around 2003/4 and a pronounced. The main reason for the pick-up in stabilisation thereafter. A broadly similar picture structural difference in real terms seems to be a emerges for the comparison with the US. Owing rising share of the manufacturing sector and an in particular to the significantly larger services again falling share of services activities, contrary sector in the US (above 78%), the structural to movements in both the old Member States and distance between the new Member States and the the US. These trends point to the significance of US is appreciably larger than with the EU-15- changes in relative prices rather than real output

European Commission

Five years of an enlarged EU

Table VI.2: Output composition in real terms

% of gross value added 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Agriculture OMS 2.3 2.3 2.3 2.3 2.3 2.2 2.1 2.1 2.0 2.1 2.0 1.9 NMS 7.2 6.9 6.8 6.5 6.4 5.8 6.1 6.0 5.9 6.4 5.8 5.4 Construction OMS 6.2 6.0 5.8 5.7 5.7 5.5 5.5 5.5 5.5 5.4 5.4 5.5 NMS 7.1 7.2 7.1 7.3 6.9 6.7 6.3 6.1 5.8 5.8 6.0 6.3 Manufacturing OMS 19.4 19.1 19.3 19.3 19.1 19.3 19.1 18.8 18.6 18.6 18.5 18.6 NMS 19.2 19.7 20.2 20.0 20.4 21.2 21.1 21.2 21.9 22.7 23.2 24.4 Energy OMS 2.9 3.0 2.9 2.9 2.9 2.8 2.8 2.8 2.8 2.8 2.7 2.6 NMS 5.7 5.7 5.5 5.3 5.0 5.0 4.6 4.4 4.2 4.2 3.9 3.5 Services OMS 69.1 69.6 69.7 69.9 70.0 70.1 70.4 70.8 71.1 71.0 71.4 71.4 NMS 60.7 60.4 60.4 60.9 61.4 61.4 61.8 62.3 62.2 61.1 61.2 60.7 Distance OMS-NMS 8.6 9.2 9.2 9.0 8.6 8.7 8.6 8.4 8.9 10.0 10.2 10.8 OMS-US 8.5 7.9 7.8 7.4 7.4 7.1 7.9 7.4 7.4 7.2 6.9 7.1 NMS-US 16.2 16.6 16.5 16.1 15.7 15.5 16.3 15.7 16.1 17.1 17.1 17.9

Note: Distance: see Table VI.1. NMS excluding Malta Source: Commission services (AMECO)

redistribution in the new Member States and new Member States, a clear convergence in (Balassa-Samuelson effect). export composition emerges over time, indicative of more homogeneous trade patterns, i.e. Graph VI.1: Trade specialisation increasing intra-industry trade (Graph VI.1, see

35 also Chapter III.1.4).

Distance (in export structure between NMS and

OMS) Summing up

30 STIC 3-di gi t

The analysis sends mixed signals as to the likely impact of trade developments on business cycle

25 synchronisation. Looking at export structure by

destination, the share of old in new Member C N 2-digi t States' total exports has decreased over the last

20 decade on account of stronger intra-EU-12 trade

and trade with CIS countries. On the other hand, the share of the new in old Member States' total

15 exports has increased. Measured by output

99 00 01 02 03 04 05 06 07 composition in real terms, the structure of new

Note: Distance: see Table VI.1 Member States' economies still seems to be

Source: Commission Services(Comext) significantly different from that of old EU Member States, pointing to further need for

Product and trade specialisation structural convergence. However, the quality of

trade flows in goods between new and old

The analysis has so far described developments Member States seems to have become more in broad sectoral composition rather than in homogeneous. Despite remaining differences in actual product specialisation. An analysis using a non-merchandise sectoral composition, the deeper industrial breakdown into 56 industries apparent gain in importance of intra-industry broadly confirms the above results for Poland, trade would speak in favour of an increasingly the Czech Republic, Hungary and Slovakia for homogeneous effect of sector-specific shocks on the period up to 2003( 53 ). Comparing export the two groups of countries, thus fostering the

shares for 99 and 158 product categories (CN 2- synchronisation of their business cycles.

digit and STIC 3-digit breakdown) between old

( 53 ) The distance indicator as in Table V.1, computed over

industrial shares (ISIC rev 3) in value added at current prices, declines slightly from 23.4 in 1995 to 21.1 in 2003 on average across the four countries.

Chapter VI

Integrating in the EU or in the world?

• 2. 

  BUSINESS CYCLE SYNCHRONISATION across the new Member States. Covering all

  BETWEEN NEW AND OLD MEMBER twelve countries, Afonso and Furceri (2007) find STATES: THE EMPIRICAL PICTURE Cyprus, Hungary and Malta to be highly synchronised with EMU countries. At the same

Subsequent to the indirect, theoretically-founded time, synchronisation seems to have increased approach of the previous section, this section over time overall. On a sectoral level, their looks directly at empirical measures of business results suggest that the industry, building and cycle synchronisation. Cross-country correlations agricultural sectors are the main driving forces of of output fluctuations, measured by de-trended synchronisation, while the services sector is GDP, and other measures of synchronisation are characterised by a low level of synchronisation. used. To gauge which components of output Artis, Marcellino and Proietti (2004) find that have the highest degree of synchronisation, a cyclical synchronisation with Germany is large separate analysis is carried out for expenditure for Poland, Slovenia, Estonia, Hungary and the and sectoral GDP components. Czech Republic.

2.1. Overview of previous findings In a meta study, Fidrmuc and Korhonen (2006)

provide a comprehensive overview of the Owing to the relatively short data samples and literature on business cycle synchronisation and the wide variety of business cycle indicators and the (a)symmetry of macroeconomic shocks de-trending methods used, the literature on between new Member States and the euro area. business cycle synchronisation of the new Analysing 35 studies, the highest average Member States has arrived at highly variable estimates of business cycle correlation with the conclusions. One rather general result is that euro area are found for Hungary (0.36), followed synchronisation with the old Member States by Slovenia (0.26) and Poland (0.25). In several seems to be present, but at a lower average level studies, the cycles of one or more new Member than for individual old Member States. Similar States are found to be correlated more closely conclusions emerge concerning inflation. The with the euro area than one or more peripheral results differ considerably across countries, euro area economies (Portugal, Ireland and reflecting the heterogeneity of the new Member Finland). It has to be noted, though, that the States and making general conclusions hard to study summarises findings that are based on data draw. Lastly, most contributions target the samples typically ending in or before 2002, i.e. degree of synchronisation with the euro area not covering developments over the latest six rather than the old Member States with a view to years. gauging the new Member States' preparedness

for EMU enlargement. 2.2. Empirical analysis

Analysing synchronisation between the EMU 2.2.1. GDP-based synchronisation

and the eight Central and Eastern European countries, Darvas and Szapáry (2008) find that Following established practice in the literature, Hungary, Poland and Slovenia have achieved a filtered GDP series are used to measure

high degree of synchronisation with the EMU for countries' business cycles ( 54 ). Four measures of

GDP, industrial production and exports, but not synchronisation are calculated on the basis of the for consumption and services. For the other derived series. countries, they find less or no synchronisation.

Using impulse response analysis, Slovenia and

Poland are found to be most sensitive to euroarea

 shocks. Eickmeier and Breitung (2006) use ( 54 ) The Christiano and Fitzgerald (2003) bandpass filter is

a large-scale structural factor model to analyse used, extracting swings of between one and a half and

the variance shares of output and inflation eight years periodicity, in line with the general notion of the business cycle. As a robustness check, the two-sided

explained by common euro-area factors. The HP-filter version proposed by Artis, Marcellino and

proliferation of euro-area shocks appears rather Proietti (2003) was also used. In general, the two

similar for new and old Member States, masking, methods led to very similar estimates of the business cycle and the results proved robust using either of the

however, a considerable degree of heterogeneity two filters.

European Commission

Five years of an enlarged EU

Given the interest in the temporal development Table VI.3: Business cycle correlation: new Member States of business cycle synchronisation, the measures with old Member States aggregate are calculated for sub-periods and, in the case of 95-08 95-01 02-08

the correlation measure, also using a four-year BG 0.49 0.53 0.64

rolling window. Given that in the early 1990s CY 0.80 0.78 0.85

several new Member State were in "transitional CZ 0.23 0.16 0.60 EE 0.14 -0.10 0.72

recession", the analysis excludes pre-1995 data. HU 0.38 0.42 0.34

The total sample from 1995 to 2008 is divided LT -0.29 -0.41 0.08 into the sub-periods 1995 to 2001 and 2002 to LV 0.59 0.40 0.86

2008 ( 55 ). The slight deviation from the natural MT na na 0.52 division into pre- and post-2004 data is PL 0.47 0.55 0.34

warranted by the need for robust estimation SI 0.59 0.39 0.86

results in the sub-periods, where five years of SK -0.36 -0.45 -0.16 NMS 0.30 0.23 0.51

quarterly data would constitute an unreasonably OMS 0.77 0.76 0.81

small data sample. Moreover, given that Note: NMS and OMS are unweighted averages. NMS excludes Malta economic agents are forward-looking, it can be Source: Commission services argued that the synchronisation-enhancing

effects of EU accession were already largely To put this into perspective, the average contained in the data two years before actual correlation of individual old Member States with accession took place. Apart from old and new the EU-15 aggregate is as high as 0.77 over the Member State data, OECD and US data are full sample, with a minimum value of 0.61 examined with a view to separating European attained for the peripheral countries Finland and integration from broader globalisation trends. Portugal. The rather steep increase in correlation

of the new Member States on average in the

Correlation second sub-period is due to increases in all

countries but Poland and Hungary, where

The first measure of synchronisation is the correlations decreased from above-average contemporaneous correlation between the EU-15 values in the first sub-period. In the post 2002 and new Member States' cycles. This measure is sample, correlation is clearly above average for widely used in the literature, providing a simple, Bulgaria, Cyprus, the Czech Republic, Estonia, robust and intuitive measure of cyclical co Latvia and Slovenia, average for Malta, and movement. below average for Lithuania and Slovakia, but

also Poland and Hungary. Over the full sample, only Cyprus, Latvia and

Slovenia display a bilateral correlation with the The development of average synchronisation EU-15 aggregate in excess of 50% (Table VI.3), over time demonstrates that the message depends with Poland and Bulgaria scoring just below that crucially on whether individual correlations are threshold. On average across countries, weighted with countries' GDP shares (Graph correlation is at 0.30 over the full sample, and VI.2). While the un-weighted average displays a has risen significantly from 0.23 in the first to clear upward trend, with a temporary dip in

0.51 in the second sub-period ( 56 ). 57 2003/4 ( ), the case for increased

synchronisation is less clear when looking at the

( 55 ) Seasonally-adjusted quarterly data is used, extended idiosyncrasy on the aggregate figure. Reflecting the

using Commission forecasts where available Quarterly dominant share of Poland and Hungary in new Member National accounts data for Romania and Malta is not States' GDP, correlation of the new Member State available before 2000, and for Romania only in nonaggregate has actually fallen somewhat to 0.75 in the

seasonally adjusted form. Therefore, the country had to second sub-period.

be excluded from most of the analysis, while a partial ( 57 ) This temporary fall in correlation around 2003, which is

analysis is carried out for Malta. also visible in intra-euro area correlation, seems to mirror

( 56 ) For comparison, the average correlation of the aggregate a recurrent pattern of temporary de-synchronisation in

NMS cycle with the aggregate EU-15 cycle is as high as the early upswing phase of the business cycle, see Gayer 0.82 over the full sample, reflecting, however, the (2007) for evidence on the EA and Doyle/Faust (2002)

smoothing impact of combining country-specific on the G7.

Chapter VI

Integrating in the EU or in the world?

weighted average of individual correlations. This Member States with global cyclical conditions mainly reflects the high degree of EU-15 proves to be significantly lower than with the correlation of the Polish cycle before 2002, EU-15 cycle (Table VI.4). Over the 2002-08 followed by the temporary decline in 2003-2004 period, average correlation with the US cycle is (Graph VI.3). Looking at very recent at 21%, up from 8% in the 1995-99 period, but developments, upward trends in synchronisation markedly lower than the 51% EU-15 benchmark. are evident for all three Baltic countries, Malta, In contrast to the EU-15 results, Hungary and Poland, Slovakia and, to some extent, Slovenia. Poland (with Cyprus) stand out as countries with Cyprus clearly shows the highest and most stable the highest bilateral correlations with the global level of correlation with the EU-15 cycle. cycle measure.

Graph VI.2: Average rolling business cycle correlations Table VI.4: Business cycle correlation: new Member States between old and new Member States with the US

1.0 95-08 95-01 02-08

0.9 BG 0.19 0.25 0.02

CY 0.51 0.46 0.64

0.8 CZ -0.16 -0.28 0.22

0.7 EE -0.03 -0.23 0.39

we i ghte d ave rage

0.6 HU 0.67 0.71 0.64

LT -0.21 -0.31 0.03

0.5 LV 0.20 0.10 0.32

0.4 MT na na -0.02 PL 0.54 0.49 0.59

0.3

SI 0.23 0.31 0.17

0.2

unwe i ghte d ave rage SK -0.72 -0.74 -0.70 0.1 NMS 0.12 0.08 0.21

0.0 Note: NMS average (unweighted) excluding Malta 97 98 99 00 01 02 03 04 05 06 07 Source: Commission services

Source: Commission services

Leads and lags

Graph VI.3: Individual rolling business cycle correlations

between old and new Member States The second synchronisation measure is based on the lead or lag for which the correlation between

1.0 1.0

0.8 0.8 two cycles is maximised (

59

). Thus, a value of

0.6 0.6 0.4 0.4

BG zero indicates that correlation is highest for a

0.2 0.2

0.0 CZ 0.0 contemporaneous relationship, while negative

-0.2 LT -0.2 EE

-0.4 -0.4 MT values indicate a lead and positive values a lag of

-0.6 -0.6 CY

-0.8 -0.8 new Member States' cycles with respect to the

-1.0 -1.0

97 98 99 00 01 02 03 04 05 06 97 98 99 00 01 02 03 04 05 06 EU benchmark.

1.0 1.0 0.8 0.8 0.6 0.6

0.4 0.4 On average, new Member States' cycles appear

0.2 0.2 to be in sync with the EU-15 cycle, particularly

0.0 0.0 -0.2 -0.2

LV in the more recent sub-period since 2002 (Table

-0.4 -0.4

-0.6 SI HU -0.6 VI.5). Focusing on this latter period, significant

-0.8 -0.8 PL SK

-1.0 -1.0 time shifts (more than two quarters) are

97 98 99 00 01 02 03 04 05 06 97 98 99 00 01 02 03 04 05 06

perceivable only for Hungary (leading the EU Source: Commission services cycle), Lithuania, Malta and Slovakia (lagging).

With respect to the US cycle, the countries are on

Taking the US cycle as a reference for the world average lagging slightly behind, increasingly so cycle ( 58 ), average correlation of the new

( 59 ) Correlations are calculated for a maximum time shift of ( 58 ) The results are qualitatively unchanged when the OECD three quarters. Therefore, a value of 3 indicates a lag of

aggregate is taken as a reference for the world cycle. three quarters or more.

European Commission

Five years of an enlarged EU

in the second sub-period ( 60 ). This indirectly Table VI.6: Volatility of new Member States' cycles

confirms the common finding that the US is OMS=100 95-08 95-01 02-08 leading the EU cycle. Together, the analysis of BG 570 709 169 leads and lags provides further evidence of a CY 158 172 129

stronger business cycle synchronisation with the CZ 251 303 114

old Member States than with global EE 374 411 304

developments. HU 155 134 186 LT 310 354 205

LV 308 246 394 Table VI.5: Leads and lags of new Member States' business MT na na 159

cycles versus old Member States and the US PL 143 137 153

old Member States United States SI 110 87 142 95-08 95-01 02-08 95-08 95-01 02-08 SK 199 200 193 BG 1 0 2 3 3 3 NMS 258 275 199 CY 1 1 0 3 3 3 OMS 159 162 140 CZ 3 3 0 3 3 2 Note: Volatility measured by standard deviation relative to OMS.

EE 1 1 -2 3 2 3 NMS average (unweighted) excluding Malta HU -3 -2 -3 0 0 -1 Source: Commission Services LT 3 3 3 -3 -3 -1 LV 1 1 0 3 3 3

MT na na 3 na na 3 Looking at some individual old Member States

PL -1 -1 -1 0 1 -1 for comparison, the relative standard deviation of

SI 0 -2 1 3 3 3 Germany to the EU-15 is 136, while for Belgium SK 3 3 3 -3 -3 3 it is 272 over the full sample. On average across NMS 1 1 0 1 1 2 all EU-15 countries, it is 159. Between the first Note: NMS average (unweighted) excluding Malta and the second sub-period, the distance between

Source: Commission services old and new Member States' cyclical volatility

has shrunken, indicative of a diminished role of

Volatility of cycles country-specific shocks. While, since 2002, the

volatility of many new Member States' cycles is

Business cycle volatility is measured by standard about the same as in EU-15 countries (Cyprus, deviations, expressed in relative terms to the EU- the Czech Republic, Malta, Poland, Slovenia), it

15 aggregate. A decrease in the relative volatility remains significantly higher on average.

can be interpreted as a diminishing role of

country-specific disturbances. Persistence of cycles

In line with global and European trends, there The last measure is the first-order autocorrelation has been a trend towards less volatility in the coefficient of business cycles, used as a rough majority of countries, with the average volatility but straightforward summary measure of their measure declining from 275 in 1995-2001 to 199 persistence (OECD, 2002). The rationale for this in 2002-08 (Table VI.6). Over the full sample, measure is that the dynamic effect of any shock relatively low volatility is observable for Cyprus, depends on the degree of persistence of the Hungary, Poland and Slovenia. Over the more series, with shocks having a longer-lasting effect recent sub-period, Bulgaria, the Czech Republic on highly persistent series. Consequently, a and Malta likewise display below-average similar degree of persistence is important from volatility. the perspective of business cycle

synchronisation ( 61 ). Furthermore, noisy series

In interpreting the magnitude of the values, it has to be borne in mind that a single cycle is (almost) necessarily more volatile than an aggregate of several country cycles. ( 61 ) This simple measure is not suitable for identifying

individual (supply and demand) shocks and transmission mechanisms, but rather reflects the similarity of the aggregate effect of the various shocks and their transmission. An important caveat is that the persistence of the business cycle is often linked to underlying

( 60 ) The same result is obtained when the OECD cycle is structural and institutional features of the economies,

taken as global reference. including size and openness.

Chapter VI

Integrating in the EU or in the world?

tend to show lower autocorrelation. Therefore, first, consumption appears clearly less low persistence compared to other countries can synchronised than GDP, thereby confirming the also point to the relative importance of country "consumption-correlation puzzle" (Backus, specific shocks. Kehoe and Kydland, 1992). According to

conventional macroeconomic reasoning, Table VI.7: Persistence of cycles in the new Member States consumption should be more closely related than

95-08 95-01 02-08 output across financially integrated countries. BG 0.85 0.85 0.88 However, average correlation with the EU-15 is CY 0.93 0.93 0.92 close to zero across the sample (Table VI.8). At

CZ 0.90 0.90 0.80 the individual country level, this hides some

EE 0.90 0.89 0.91 significantly positive (Cyprus, Lithuania, Malta)

HU 0.91 0.89 0.93

LT 0.91 0.92 0.81 and negative (Estonia, Slovakia) correlations.

LV 0.92 0.88 0.94 While there is a slight upward slope in mean

MT na na 0.83 correlation in recent years (Graph VI.4),

PL 0.83 0.74 0.87 synchronisation has not increased on average SI 0.91 0.87 0.93 over the two sub-samples.

SK 0.90 0.87 0.95

NMS 0.89 0.87 0.89 Graph VI.4: Rolling correlations of demand components in

OMS 0.90 0.89 0.89 new and old Member States

Note: First order autocorrelation coefficients. NMS and OMS are

1.0 Consumption 1.0 Investment

unweighted averages. NMS excludes Malta 0.8 0.8

Source: Commission service 0.6 0.6

0.4 0.4 0.2 0.2 0.0 0.0

Tracking the persistence measures of new -0.2 -0.2 -0.4

EU_NMS -0.4 EU_NMS

Member States' business cycles shows that from -0.6 OECD_NMS -0.6 OECD_NMS -0.8

US_NMS -0.8 US_NMS

1995-2001 to 2002-2008, cyclical persistence -1.0 -1.0

97 98 99 00 01 02 03 04 05 06 97 98 99 00 01 02 03 04 05 06

appears to have increased slightly on average 1.0 Exports 1.0 Imports

(Table VI.7). While average persistence across 0.8 0.8 0.6 0.6 new Member States was slightly lower than 0.4 0.4 0.2 0.2 across EU-15 countries in the first sub-period, it 0.0 0.0 -0.2 -0.2 rose to the average EU-15 level (of 0.89) -0.4 EU_NMS -0.4 EU_NMS -0.6

OECD_NMS -0.6 OECD_NMS

thereafter, implying that the aggregate effect of -0.8 -0.8 US_NMS US_NMS -1.0 -1.0 symmetric shocks and their transmission has 97 98 99 00 01 02 03 04 05 06 97 98 99 00 01 02 03 04 05 06

become more similar. Given that the degree of Source: Commission services

persistence in a given economy is linked to underlying structural features such as size and

openness, it is difficult to draw country-specific Reflecting the apparent dissociation of conclusions from the table. One remarkable consumption cycles across countries, correlation development seems to be the significant increase with respect to the EU-15 is not higher than with in persistence of the Polish business cycle in the respect to the US or OECD. So the data do not second sub-period, indicative of the diminished support the hypothesis of e.g. Darvas and

importance of country-specific disturbances. Szapáry (2008) that with increasing financial integration the "consumption-correlation puzzle"

would eventually be solved ( 63 ).

2.2.2. Synchronisation of expenditure and sectoral components

This section extends the correlation analysis to

the major expenditure and sector components of data are available from 2000 only, is likewise not

GDP ( 62 ). Looking at expenditure components included in any of the averages. ( 63 ) Imbs (2004b) shows that a persistent positive gap

between GDP and consumption correlation can be explained by the fact that financial integration empirically raises GDP correlation as much as it raises consumption correlation. While this explains the

( 62 ) Bulgaria and Romania had to be excluded from the persistence of the consumption-correlation puzzle, it

analysis due to lack of quarterly data. Malta, for which cannot explain why in the new Member States the gap European Commission

Five years of an enlarged EU

Table VI.8: Correlation of expenditure components in new Member States with old Member states

CY CZ EE HU LT LV MT PL SI SK average

95-08 0.55 -0.16 -0.57 0.02 0.65 0.18 na -0.36 0.21 -0.69 -0.02 95-01 0.64 -0.17 -0.83 0.23 0.75 0.04 na -0.42 0.25 -0.77 -0.03 02-08 0.31 -0.18 0.25 -0.59 0.49 0.41 0.65 -0.18 -0.17 -0.37 0.00 Investment 95-08 0.13 -0.05 -0.38 -0.09 -0.52 -0.01 na 0.41 0.03 -0.58 -0.12 95-01 0.07 -0.17 -0.47 -0.04 -0.61 -0.15 na 0.30 0.07 -0.73 -0.19 02-08 0.29 0.17 -0.11 -0.15 -0.22 0.45 0.45 0.78 -0.03 0.02 0.13 Exports 95-08 0.65 0.80 0.83 0.82 -0.06 0.40 na 0.51 0.85 0.12 0.55 95-01 0.63 0.83 0.86 0.85 -0.02 0.41 na 0.61 0.92 0.07 0.57 02-08 0.67 0.73 0.77 0.77 -0.13 0.44 0.50 0.21 0.71 0.23 0.49 Imports 95-08 0.48 0.29 0.68 0.74 -0.47 -0.06 na 0.28 0.70 0.08 0.30 95-01 0.45 0.35 0.62 0.79 -0.49 -0.23 na 0.18 0.90 -0.16 0.27 02-08 0.50 0.14 0.90 0.66 -0.47 0.43 0.69 0.48 0.39 0.61 0.40

Source: Commission services

New Member States' investment displays a slight trade as the main channel through which upward trend over the sample in terms of synchronisation occurs. A comparison with the correlation with the old Member States, but not US and OECD shows that trade synchronisation with the US or OECD. Nevertheless, the level of is higher with the EU-15, particularly for

correlation remains low. Only Poland and, to a exports. lesser extent, Latvia and Malta display a significantly positive correlation in 2002-2008. The breakdown of GDP into its major sectoral components, ( Table VI.9) i.e. gross value added The correlation of exports is quite high and in industry and services, shows that on average stable over the sample, exceeding the correlation across countries correlation of industrial output

of GDP ( 64 ). At the country level, most countries has been rather stable over the sample, with a

display a significantly positive correlation, slight increase since 2004. The Czech Republic, Lithuania and Slovakia being the major Hungary, Poland, Slovenia and Estonia show exceptions. While Poland displays a fall in high positive correlations overall, though there correlation in the second sub-period, an analysis were declines in the second sub-period in all but of rolling correlation coefficients shows that after the Czech Republic, where correlation increased temporary de-synchronisation with the EU in further to a high level of 75%. The correlations 2000-03, export cycles have more recently of value added in services broadly mirror the become increasingly synchronised again. developments in GDP correlations, reflecting the dominant weight of the services sector in the Import cycles exhibit similarly smooth economy. At the country level, the high value of developments, albeit around an increasing trend services correlation in the 2002-08 period is

and at a slightly lower level ( 65 ). The most mainly due to Cyprus, Estonia, Latvia, Slovenia

significant increases in import correlation are and Slovakia, with values around 0.8. discernible for Estonia, Latvia, Poland and Slovakia, while correlations are lower in the second sub-period for the Czech Republic and Slovenia. Altogether, the results point to foreign

between output and consumption correlations is actually widening, with the former increasing and the latter remaining unchanged.

( 64 ) The slight fall in the second sub-period seems to reflect

the above-mentioned general pattern of temporary desynchronisation in the early upswing phase of the business cycle.

( 65 ) The lower level is explicable by the fact that imports are

generally more sensitive to domestic shocks.

Chapter VI

Integrating in the EU or in the world?

Table VI.9: Correlation of sectoral output cycles in new Member States with old Member states

CY CZ EE HU LT LV PL SI SK average Industrial production

95-08 -0.14 0.60 0.49 0.63 -0.19 0.05 0.50 0.71 -0.51 0.24 95-01 -0.02 0.55 0.51 0.73 -0.18 0.09 0.67 0.78 -0.83 0.26 02-08 -0.42 0.75 0.39 0.25 -0.20 -0.11 0.24 0.60 -0.12 0.15 Services

95-08 0.87 -0.03 0.01 0.33 -0.09 0.74 0.40 0.31 0.07 0.29 95-01 0.91 -0.22 -0.32 0.20 -0.04 0.63 0.47 0.05 -0.13 0.17 02-08 0.80 0.25 0.83 0.52 -0.24 0.94 0.25 0.83 0.76 0.55

Source: Commission services

Graph VI.5: Rolling correlations of sectoral output in new and concludes that the overall effect of trade on

old Member States synchronisation is strong, but a sizeable part is

found to work through intra-industry trade.

Ave rage NMS corre l ati on wi th O MS

0.9 Moreover, similar specialisation patterns are found to have a sizeable direct effect on business

0.7 cycle correlation. Fidrmuc (2004) finds that the

link between cyclical synchronisation and trade intensity becomes insignificant once regressions

0.5 in dustry are augmented by additional structural variables.

se rvi ce s In a similar vein, Inklaar, Jong-A-Pin and De 0.3 Haan (2008) find that the effect of trade intensity

on synchronisation is much smaller than 0.1 previously reported, with other structural

variables such as trade similarity, similarity of -0.1 monetary and fiscal policies and degree of

97 98 99 00 01 02 03 04 05 06 07 financial integration having an effect at least as Source: Commission services strong. Artis, Fidrmuc and Scharler (2008)

conclude that, while trade and financial flows

The analysis of sector developments points to an tend to increase business cycle co-movements increasing synchronisation of service sector between countries, divergent fiscal policies and activity between old and new Member States labour market rigidities delay the (Graph VI.5). In contrast to most previous synchronization of business cycles.

studies, correlation of activity in services has on

average been found to be higher than in industry Most of the literature analyses the determinants since around 2002. of business cycle synchronisation using a crosssection

 of OECD or euro-area countries. Traistaru (2004) analyses the transmission

• 3. 

  ESTIMATING THE RELATIONSHIP channels of synchronisation in a hypothetical

  BETWEEN SYNCHRONISATION AND euro area, enlarged by the eight Central / Eastern ECONOMIC INTEGRATION European countries. She finds structural

  similarity and bilateral trade intensity to be

This section presents econometric estimates of significantly and positively related to business the relationship between business cycle cycle synchronisation. However, these results synchronisation and various measures of apply to country pairs including within-euro area economic integration. Following the seminal and within new Member States combinations. paper by Frankel and Rose (1998), many studies The explicit determinants of synchronisation have confirmed the finding that countries with between old EU Member States on the one hand

more intense trade ties have more similar business cycles. However, to disentangle the effect of inter-industry trade from that of intraindustry trade, a measure of specialisation has to be added to the equation. Imbs (2004a)

European Commission

Five years of an enlarged EU

Table VI.10: Determinants of synchronisation: model results

Ordinary least squares Instrumental variable -0.009 -0.004 -0.044 -0.017 (-0.27) (-0.16) (-0.92) (-0.58)

Difference in trade structure (specialisation) -0.24 -0.050 -0.346* -0.092 (-1.42) (-0.45) (-1.76) (-0.75)

Dissimilarity of monetary policy -0.167*** -0.071* -0.156*** -0.066* (-3.58) (-1.91) (-3.23) (-1.77)

Dissimilarity of fiscal policy -0.02 -0.022* -0.023 -0.022* (-1.26) (-1.82) (-1.28) (-1.83)

Financial integration 0.443*** -0.105 0.471*** -0.094 (2.63) (-0.95) (2.76) (-0.84)

Dummy for LT and SK -0.923*** -0.927*** (-17.35) (-17.22)

Hausman test (H0: OLS is consistent), p-value 0.13 0.36

Note: trade intensity: sum of bilateral trade flows (exports and imports) divided by total trade flows of the country pair, average over 1999-2007 (expected sign: +); difference in trade structure: sum of absolute bilateral differences in export shares across 99 product categories (CN 2 digit commodity groups), average over 1999-2007 (expected sign: –). To the extent that the export structure reflects that of total industry, the measure can also be viewed as a measure of industrial specialisation. Dissimilarity of monetary policy: absolute bilateral differences of short-term nominal interest rates, average over 1999-2007 (expected sign: –); dissimilarity of fiscal policy: absolute differences of cyclically adjusted budget balance, average over 1999-2008 (expected sign: –); financial integration: bilateral correlations of quarterly growth in stock-indices, computed over 1999- 2008 (expected sign: +). Constants included; t-statistics, consistent for heteroscedasticity in parentheses; *,**,*** denote significance at 10, 5 and 1 percent levels. The following variables were included in the instrument variables estimations: distance between capitals, common border dummy, population and real GDP to control for size effects. Source: Commission services

and the new Member States on the other have not financial integration likewise seems to be

yet been sufficiently addressed ( 66 ). significantly (positively) related to output

correlation, this result is not robust to the The estimation results are based on 165 crossinclusion of the dummy for the two least section observations of bilateral correlation synchronised countries. Finally, differences in coefficients between new and old Member States fiscal policy are estimated to have a significant

( 67 ). Bilateral trade intensity turns out to be negative impact on output synchronisation, at

insignificant in explaining pair-wise output least after correcting for the low level of

correlations (Table VI.10). The results suggest synchronisation of Lithuania and Slovakia.

that the Ordinary Least Square estimation is

consistent and close to the Instrumental variables

results ( 68 ). The trade specialisation measure is 4. SUMMARY AND CONCLUSIONS

significant at the 10% level in the Instrumental Variables estimation approach. Differences in While new and old EU Member States can be monetary policy appear to have a significantly characterised by a fairly high degree of negative impact on synchronisation, even after integration, recent developments in trade correcting for the markedly lower level of integration and structural similarity are synchronisation of Lithuania and Slovakia with ambivalent. The share of new Member States' EU-15 countries via a dummy variable. While exports going to the old Member States has been decreasing in recent years, thus exposing them more to non-EU demand shocks. Moreover, there are remaining or, in real terms, even increasing ( 66 ) This is hampered by limited data availability for the new

Member States and by the fact that the countries have structural differences between new and old

been undergoing important structural changes and Member States. On the other hand, the quality of

catching-up, thus rendering the estimations in all trade flows has become more homogeneous,

probability less robust than when comparing crosssections

of developed countries. indicative of more intra-industry trade that is

( 67 ) Correlations, computed on filtered quarterly GDP data expected to promote a symmetric propagation of

over 1999-2008, are transformed using Fisher's zshocks.

transformation to ensure normality, see Inklaar, Jong-A- Pin and De Haan (2008) for details. As before, Romania

had to be excluded from the analysis. The empirical analysis points to a preferential

( 68 ) Endogeneity of trade was tested using the Hausman degree of synchronisation of the new Member

(1978) test.

Chapter VI

Integrating in the EU or in the world?

States with the old Member States as compared to be due to a strong increase in services to the global business cycle. Synchronisation, as correlation since 2002. The latter two countries, measured along four different dimensions, also together with Hungary, also score lowest on the seems to be rising over time. The analysis of lead/lag criterion. expenditure components suggests that fairly synchronous swings in trade flows contribute Looking at the determinants of cyclical most to the synchronisation of overall output in synchronisation using an econometric model, the enlarged EU. The puzzle of low consumption synchronisation between new and old EU correlation remains. At the sector level, services Member States does not seem to be bolstered by are becoming increasingly synchronised. higher trade intensity as such. However, there is

some evidence that the similarity of trade For two of the largest countries, Poland and patterns matters for business cycle Hungary, the level of correlation with the old synchronisation. Together, this suggests that Member States over the past seven years is intra-industry rather than total trade is supportive below new Member State average and lower than in synchronising the new with the old EU correlation with the US. Yet, looking at very Member States. Moreover, it appears that similar recent developments in rolling correlations, an monetary policy and, to a lesser extent, fiscal increase in correlation (or an already very high policy and financial integration are important level) is observed for the large majority of factors in explaining why some countries are countries, including Poland. Looking at all better synchronised with the old Member States synchronisation measures together, the findings than others. across countries are broadly in line with previous studies: Cyprus, the Czech Republic, Malta,

Poland and Slovenia are characterised by a relatively high level of synchronisation with the

EU-15. Apart from extreme volatility in the first half of the sample, Bulgaria likewise seems to be well-synchronised.

Hungary, however, scores relatively low on the analysed dimensions of cyclical synchronisation compared to the earlier findings in the literature, which were based on shorter data samples.

Arguably, the substantial fiscal slippages in recent years have contributed to the idiosyncratic behaviour of the Hungarian business cycle.

Among the Baltic countries, Estonia and Latvia are found to be quite highly correlated with the

EU-15, but high cyclical volatility remains a common feature. Estonia's noticeable rise in

GDP correlation in the post-2002 period appears to be driven by services, while the industry sector too maintains a reasonably high correlation. Latvia's high GDP correlation across the sample is also driven by services, while the industry sector remains unrelated to EU-15 developments. Only Lithuania keeps showing low or even negative correlation across the board, though the rolling correlations point to a strong upward trend in very recent years. Similar results apply for Slovakia, where the very recent positive developments in GDP correlation appear

Chapter VII

Enlargement and the EU policy framework

SUMMARY OF MAIN FINDINGS

Part of the success in the catching-up process can On their way to becoming EU members, the new be attributed to the EU policy framework which Member States have made significant progress in the new Member States had to adopt as part of implementing structural reforms. This endeavour the Accession Treaty. The essential building has continued after accession in the context of blocks of the EU governance mechanism are: the the Lisbon strategy for growth and jobs. In view rules relating to the Single Market, the Lisbon of the diversity of economic structures in the EU, agenda to foster structural change, fiscal which has been further accentuated by surveillance and Economic and Monetary Union enlargement, and also the fact that many to ensure macroeconomic stability and, lastly, the structural reforms traditionally fall within the efficient use of EU transfers of which the new remit of national governments, a soft approach to Member States are the main beneficiaries. co-ordination is followed, relying on tools such Respect for the EU economic and policy as headline targets, guidelines, peer review, framework leads to a level playing field in 27 benchmarking, etc. The new Member States are countries which benefits consumers and firms now fully integrated into the Lisbon strategy and who have access to a large unified market have gained from the putting in place of governed by the same set of rules. institutional arrangements that facilitate

coordinated and coherent policy-making in the On the whole, the Single Market regulations area of structural reforms. The evidence shows have been quickly implemented in the new that the overall pace of reform in the new Member States, which have a similar Member States continues to be substantial, transposition deficit and fewer infringement though some indicators point to signs of reform cases on average than the old Member States as fatigue. well as a higher share of openly announced public procurement (5.7 % of GDP against 3.2 % Much remains to be done. There are structural of GDP). As a result, because of increased weaknesses in a number of areas and the policy competition and a catching-up effect (which efforts need to concentrate on these areas if they naturally make the low prices in the new are to have a tangible impact on growth and jobs. Member States increase), price dispersion in the This is particularly relevant in the current EU as a whole measured by the coefficient of economic crisis, which is already taking its toll variation has decreased from 38.7 % in 1995 to through labour shedding and gloomy growth 24.5 % in 2007 for comparative goods including prospects. The microeconomic area appears to be indirect taxes. However, there is still a distance the one where underperformance is much more from the low level of price dispersion of 11 % acute in new Member States than in the old observed in 2007 if only the old Member States Member States. The main underperforming are considered. policy areas are the competitiveness framework,

R&D, and innovation and ICT. Weaknesses are The heterogeneity of the EU increased after also apparent in the area of business environment enlargement, and this presents a challenge in and business start-ups. This is broadly in line terms of the management of the internal market. with the finding that the new Member States still However, greater benefits are also to be expected lag behind considerably in capital deepening and from the efficiency gains to be made thanks to total factor productivity. In order to sustain the increased competitive pressure, and from the catching-up process, attention needs to be paid to integration of new countries with different improving conditions in the policy areas that comparative advantages, so that the EU is better contribute to boosting productivity. While in placed to respond to globalisation. Enlargement some areas related to labour markets the new enhances the attractiveness of the EU as a place Member States perform rather well, there are to invest and strengthens its ability to set also significant weaknesses. In particular, active benchmarks and bring about the convergence of labour market policies are underdeveloped and rules worldwide. This facilitates exports by labour markets often exhibit high segmentation, European firms and ensures that imports meet regional disparities and skill mismatches. There EU standards. is, therefore, a need for a comprehensive

approach to structural reform if the existing growth bottlenecks are to be tackled effectively.

European Commission

Five years of an enlarged EU

Safeguarding macroeconomic stability implying some of them made significant progress and low inflation, a sustainable current account of the joined the euro area, some of the others made balance of payments and solid financial less progress or even went backwards. The four institutions is a concern for the new Member successful entrants to the euro area – Slovenia States. In this context, consolidation of public (2007), Cyprus and Malta (2008) and Slovakia finances in structural terms is key to cool off the (2009) – formulated their target dates and strong demand dynamics, especially when the strategies for the adoption of the euro in good exchange rate is no longer available as an time and successfully met the conditions for instrument of adjustment. Failure to do so can joining the group. The Baltic countries and make the unwinding of imbalances more Hungary in 2004, at the forefront of those new protracted. Some progress has been made in this Member States wanting to introduce the euro, area as only one of the six countries that joined had to postpone their timetable for adopting the in 2004 the EU with an excessive deficit, did not euro because of the difficulties in meeting the manage to correct it (namely Hungary). convergence criteria (the former because of the Nevertheless, looking beyond any such price stability criterion, and the latter, among favourable developments in headline deficits, other things, due to fiscal slippages). Other several new Member States have not yet reached countries have been more circumspect about a reassuring structural balance. This limits the their intentions to adopt the euro. Poland waited room for manoeuvre for fiscal policy to respond until September 2008 to announce a target date to the unfolding economic slowdown and may for adopting the euro in 2012. The Czech lead quickly to a return of excessive deficits. Republic has called off the initial 2009-2010 target date, due to delays in fiscal consolidation. In the long term, there does not appear to be a The approach of Romania and Bulgaria towards trade-off between the need for budgetary rigour adopting the euro seems to be more gradual at

and creating space for growth-enhancing the present time. expenditure. Strong growth increases the debtcarrying capacity of an economy, while Adoption of a single currency makes it possible sustainable public finances are conducive to to fully reap the benefits of a Single Market, as higher long-term growth. Potential tensions exchange rate volatility is eliminated, risk premia between the two roles of public finances may and transaction costs are reduced and price also be resolved by an appropriate composition transparency is enhanced. However, experience of expenditure and revenue. In this respect the shows that adopting the euro is not a ‘free lunch’, relative shares of investment spending and and the exercise needs careful preparation. In the government expenditures on wages and shorter term, the main challenges for the new administration compare favourably with those in Member States are to deal with the fall-out from the old Member States, although spending on the financial crisis, to maintain progress towards education and research is relatively low. Finally, convergence and not derail policy efforts. Taking the fact of having to observe the EU fiscal a longer-term view, policies to prepare for surveillance mechanism did not prevent the new participation in the euro area, in particular in the Member States from combining the reduction of area of product and labour markets and on the their deficits with appreciable levels of public macro-prudential dimension, are key to ensuring investment. On the contrary, it boosted fiscal a smooth adjustment to economic and financial governance in the new Member States, even shocks. though it is not yet up to the level of the old Member States, and thus contributed to growth. An efficient use of EU funds can also contribute Indeed, countries with well-developed fiscal to the catching-up process by the new Member rules do perform better than others. States. Transfers to Member States from the EU budget represented about 0.8 % of EU-27 GDP With respect to the process of euro area in 2007, of which 20% was allocated to the new enlargement, the 12 new Member States from Member States. This allocation is due to be widely differing starting points, have, over the increased to 35 % in the ongoing Financial last five years, followed various strategies Perspective 2007-2013, above their share in EU tailored to their own capacities and needs. While GDP (7 %) or EU population (20 %). The

Chapter VII

Enlargement and the EU policy framework

amounts transferred to the new Member States are considerable - representing 2.1 % of their

GDP in 2007 - and are expected to rise to 3 % of

GDP by 2013. However, they should not be unbearable for the old Member States as they stood at 0.2 % of EU-15 GDP in 2007, with only a slight increase to 0.3 % of GDP in the coming years.

Since accession, the new Member States have paid a contribution to the EU budget of somewhat less than 1 % of GDP, like the old

Member States. When transfers are taken into account, the new Member States as a group are net recipients from the EU budget to an amount of 1.3 % of GDP in 2007 while, on average, the old Member States were net contributors in 2007 with about 0.1 % of GDP.

EU transfers make a contribution to growth and convergence if they are properly targeted.

Rather than spreading funds, a focus on human capital and infrastructure concentrated on a few growth poles seems to be most effective, in combination with an improvement in the transmission of technology and innovation from the fast growing agglomerations to the poorer regions. Furthermore, the efficiency of the EU

Funds is greatly enhanced if they go together with structural reforms, foreign direct investment, a stability oriented macroeconomic policy and sufficient administrative capacity to handle the transfers correctly. The EU policy framework, including the Lisbon process and the

Stability and Growth Pact, as well as specific rules concerning EU transfers on co-financing, additionality and prioritisation should optimise the impact.

Simulations using the Commission's QUEST III model suggest a permanent long-term gain in output of as much as 4 %, which is maintained even when the inflow of EU funds stops. This assumes full absorption of the scheduled EU commitments. In the short run, some crowdingout may occur as it takes time to raise production capacity and, initially, the inflowing EU transfers will exceed the GDP impact.

• 1. 

  THE SINGLE MARKET

The enlargement of the European Union consumers and SMEs, (ii) better take into represents a challenge to both the old and the account the external dimension when defining new Member States, implying opportunities and new Single Market rules (iii) create a Single challenges for the Single Market. On the one Market for knowledge, and (iv) encompass a hand, it has increased heterogeneity inside the strong social and environmental dimension for EU, as the new Member States have a lower future Single Market policies. The following GDP per capita and different policy concerns sections review the results in these areas for the than the EU-15 Member States. This makes the new Member States. management of the Single Market more difficult.

On the other hand, enlargement also offers new 1.1.1. Deliver more results for citizens, economic opportunities to the EU as a result of consumers and SMEs

the extension of the Single Market to nearly 500 million inhabitants and of the integration of new A large number of achievements of the Single members with different competitive advantages. Market are already contributing to better This increases the benefits to be expected from functioning and more innovative markets that the Single Market in terms of efficiency gains deliver higher quality goods and services for and business developments. consumers at lower prices. However, the lack of

effective competition and fragmentation in This chapter attempts to draw the main certain markets prevent that the Single Market implications of the Single Market policy for the can effectively respond to the consumers new Member States at the light of the 2007 expectations and concerns. Moreover, the Single Single Market Review (European Commission, Market has to continue to improve framework 2007a). It documents the degree of conditions for businesses by a reduction of the implementation of the Single Market in the new constraints on businesses operating in the Member States and tries to assess the economic common European marketplace, with a particular impact of the enlarged Single Market for the EU focus on the small and medium-sized enterprises and for the new Member States. (e.g. European Commission, 2008b). In fact,

whereas large operators have been very successful in accessing the opportunities of the

1.1. MAIN LESSONS FROM THE SINGLE Single Market, small and medium-sized MARKET REVIEW businesses often find the Single Market fragmented and difficult to penetrate. Differing

The Single Market, with the four freedoms, approaches to taxation and the difficulty of benefited the European economy, contributing to finding unanimous support for a common create jobs and prosperity by promoting approach to rules on taxation can also act as a innovation and productivity growth. However, brake on SMEs penetration of the Single Market. the Single Market Review carried out by the

Commission in 2006-2007 to assess the In a recent "Survey of the Observatory of functioning of the Single Market concluded that European SMEs" (Eurobarometer, 2007b), a the potential of the Single Market has not been certain number of new Member States (Czech fully exploited. In particular, the Single Market Republic, Slovakia, Slovenia, Lithuania, Poland, has not contributed sufficiently to the and Romania) have been identified among the development of new areas of activities in sectors countries where business constraints were more with a high technology and knowledge content, felt than the EU average, but where the situation or to the expansion of activities in fast growing had not been deteriorating further. Concerning markets. Finally, the adjustment costs associated the Single Market, almost 40% of managers in with market opening were more clearly the new Member States (compared to a third in understood by consumers and SMEs than the the EU) indicated that the opportunities of the benefits of the Single Market. Therefore, the Single Market were not relevant to them, either Single Market Review came to the following because they only operate domestically, or for conclusions: there is a need to (i) put more some other reason. Among the SMEs doing emphasis on the benefits of the Single Market for business elsewhere in the EU, a large majority of

Chapter VII

Enlargement and the EU policy framework

them appreciated some important features of the over 90% of GDP (Malta) (see graph VII.1.1.).

Single Market. The most important feature in this The most integrated economies were Malta, respect is the Single Market legislation, Slovakia, Estonia and Hungary. including the harmonisation of technical standards which 46% of the new Member State Graph VII.1.1: Market integration in the new Member States

enterprises consider to have a significant 100 Ave rage val u e of i mports and e xports

importance for their business activities. The use of goods an d se rvi ce s as % of GDP 2002 90

of a same currency is the second most important 2003

Single Market feature for enterprises in the New 80

2004 2005

Member States, followed by the absence of 70 2006 border controls. The possibility to hire workers 60 2007

from other EU Member States is seen as an 50 important feature by only 17% of the enterprises 40

in the 12 new Member States. A majority of 30

enterprises also declared not to see any benefits

for their enterprise from EU-wide harmonised 20

standards replacing national regulations. 10

Concerning competition, SME managers in the 0

new Member States were more likely to report BG C Y C Z EE HU LT LV MT PL RO S I SK

intensified competition than their colleagues in Source: Eurostat, Commission services the old Member States.

The stronger growth in intra-EU trade compared

1.1.2. Take better advantage of to extra-EU trade indicates the on-going globalisation integration process of their economies into the

enlarged Single Market (see graphs III.1.5 and The Single Market is a powerful lever to reap the III.1.6 in section III.1). A noticeable upward potential benefits of globalisation. This can be trend is also observed in the evolution of the achieved via three channels: (1) it increases intra-EU FDI inflows to GDP ratio over the competitive pressure for EU firms, which 2002-2006 period (Graph IV.1.3 in section IV.1). prompts them to improve efficiency and to Total FDI inflows to GDP ratio increased less innovate and fosters competitiveness; (2) it rapidly, which may be an indication of the fiercer contributes to the enhanced attractiveness of the competition for attracting FDI with other EU as a place for investors and companies across emerging economies such as China and India the world; and (3) it enables the EU to take the compared. Nevertheless, the stronger integration lead in setting benchmarks and bringing about of the new Member States' economies into the convergence of rules worldwide, facilitating Single Market should unleash stronger exports by European firms and ensuring that competition forces that would lead their imports meet the EU standards (with respect to companies to increase efficiency, making them labour law, health, product and food safety, better able to compete in an increasingly environmental protection, public procurement, globalised world. financial regulation and accounting).

1.1.3. A Single Market for knowledge and

Since the 1990s, in relation with their trade innovation

reorientation towards the West, the increased trade integration of the new Member States' The structural change which occurred in Europe, economies was mainly with the old Member namely the sectoral specialisation towards highstates. After the EU enlargement, the deepening tech and service sectors, has raised policy of their trade integration was more among the attention towards the comparative advantage of new Member States but also with the rest of the Europe in developing and applying its world, which led to a further increase in their knowledge base. The building of a Single Market degree of market integration. In 2007 the degree for knowledge and innovation aims at increasing of market integration (goods and services) the overall effort devoted to R&D and other ranged from nearly 38% of GDP (Romania) to innovative activities as well as enhancing their

European Commission

Five years of an enlarged EU

effects throughout the European economy in 1.1.4. Encompass a strong social and terms of value added growth, employment environmental dimension creation, and other major societal needs such as

social cohesion, health, and environmental It has been recognised that market opening is protection. The building of a European Research partly resisted since it is associated with Area represents the major policy initiative aimed adjustment costs. Therefore, future Single at ensuring the development of the fifth freedom, Market policy should take account of the social the freedom of knowledge in Europe. and environmental implications of market

opening, and must be accompanied by measures

Several arguments support the creation of a that enable all citizens and businesses to take European Single Market for knowledge and advantage of new opportunities. This will innovation. Reducing barriers within the EU will certainly be more difficult for the new Member

increase both static and dynamic efficiency of States.

research activities through a better exploitation of research paths as well as employment

opportunities for researchers across Europe. 1.2. DEGREE OF IMPLEMENTATION OF THE Supporting cooperation between research SINGLE MARKET IN THE NEW MEMBER centres, universities and firms will boost research STATES

investments; cross-border cooperation in R&D

activities will allow economies of scale which, in This section examines the degree of turn, will facilitate innovative investments in implementation of the Single Market in the new high-tech sectors and frontier research where Member States on the basis of several indicators very high initial sunk costs often prevent (Single Market Scoreboard, biannually updated), technology initiative at the national level. On the such as the degree of transposition of Single supply side, a Single Market will support Market directives and the number of innovation by favouring economies of scale and infringement cases. This allows assessing the enhancing competition in research activities timeliness of the transposition of Single Market between research centres and companies, rules by the Member States, as well as the especially in the capital-good sectors. On the correctness of their application. Moreover, public demand side, a larger Single Market in procurement indicators can be used to see to technology-user sectors will provide stronger what extent the new Member States have opened

competitive incentives and greater rewards to up their public procurement markets.

innovation activities. In general, the deficit in the transposition of

These arguments suggest that the building of a Single Market directives and also the number of European Research Area will strongly benefit infringement procedures are lower in the new new Member States, which start from a weaker Member States than the EU average. Also in position in terms of national systems of terms of the degree of openness of public innovation and overall R&D investment. A more procurement the new Member States fare better

integrated Single Market appears to have favoured the catching-up effect of new Member 1.2.1. Transposition States in terms of R&D investments. Indeed, new

Member States have witnessed high growth rates The main success factors of good transposition of R&D investment (above 10%) since their performance include a good internal accession (period 2004-2006) compared to a coordination, timely action/early preparation and stationary growth rate of R&D investment at the accrued political attention and clear political EU-27 level over the same period. However, priority. In general, the deficit in the R&D intensities appear stable over time and transposition of Single Market directives is lower across countries due to the high GDP growth in the new Member States than the EU average. recorded in new Member States. Indeed, R&D New Member States have stepped up their efforts investment in the new Member States represents considerably to ensure timely transposition of only 0.8% of total GDP in 2006 compared to an Single Market legislation. Only one year after the overall figure of 1.84% for the EU-27. European Heads of State and Government agreed

Chapter VII

Enlargement and the EU policy framework

on the future transposition deficit target of 1%, Scoreboard. The Czech Republic is the only one the 2008 edition of the Single Market Scoreboard improving its performance, although at the lower shows that nine new Member States are already end of the ranking. in line with this target (Bulgaria, Estonia,

Hungary, Lithuania, Latvia, Malta, Romania, 1.2.2. Infringements

Slovenia and Slovakia). Since end 2004 the ten new Member States were capable to reduce their EU rules must not only be transposed into new deficit by 3.66 percentage points, compared to a national laws and regulations in each Member 1.88 percentage points' reduction in the old State, but their correct implementation and Member States. application have also to be ensured, which is

crucial for the credibility of the Single Market. The results already achieved by some new Looking at the number of Single Market related Member States, such as the Czech Republic with infringement procedures as proxy of the actual a reduction of the transposition deficit by 7.1 enforcement the new Member States continue to percentage points since 2004 (0.9 percentage fare relatively better with lower numbers of points within the last six months), demonstrate infringement cases than the old Member States. that significant progress can be achieved within a short period of time if the political will is there Concerning the sources of infringement against and the authorities give it sufficient priority. EU law, the highest number of cases is related to However, further efforts are required, e.g. environmental rules (23%), followed by taxation Cyprus' transposition deficit is the same as three and customs union rules (18%). Within the new years ago. As regards the increase of the Polish Member States, Poland shows a significant transposition deficit, the length of national number of infringement cases related to taxation legislation procedures and national political as well as energy and transport, whereas Malta circumstances are important factors, which has high numbers of infringement cases related render timely transposition difficult especially in to environment, employment, and energy and this country. transport.

Graph VII.1.2: Transposition deficit 1.2.3. Public procurement markets

10 Non transpose d di re cti ve s as % of total di re cti ve s

9 The progress made in the functioning of the

De c. 2004 June 2008 Single Market and in the degree of competition

8 and market access in general deserves attention

7 to concrete actions, such as the advancement in

6 access to public procurement contracts which 5 will enable procurement sensitive goods and 4 services to move freely, thus ensuring value for 3 money for taxpayers and consumers of public

2 services and fostering the competitiveness of

European suppliers in domestic and also world

1 markets. Public procurement is subject to

0

BG C Y C Z EE HU LT LV MT PL RO SI SK NMSO MS specific EU rules, which require that public

procurement must follow transparent open

Notes: BG: no data available in 2004, 0 in 2008; RO: no data

available in 2004; OMS, NMS: simple average procedures ensuring fair conditions of

Source: Commission services competition for suppliers (including nondiscrimination of foreign suppliers). Looking at

The Barcelona European Council of March 2002 the value of public procurement which is openly agreed on a 'zero tolerance' target for directives advertised as a percentage of GDP shows that, whose transposition deadline is overdue by two over the period 2004 to 2006, the new Member or more years. Latvia and Slovakia are the only States have made significant efforts to open up new Member States which achieved the target their public procurement markets.

according to the most recent Single Market

European Commission

Five years of an enlarged EU

Graph VII.1.3: Value of public procurement which is openly additional opportunities to draw on a wider range

advertised of comparative advantages characterising the

% of GDP different Member States. This is a source of

14

2004 2005 2006 further dynamism and efficiency in the Single

12 Market. On the other hand, while the economic

changes induced by this enlargement have been 10 absorbed quite smoothly and there is no evidence

8 of disruptive impacts on the product and labour

markets, the increased divergence among the 6 EU-27 countries has augmented the risks of

tensions within the Single Market.

4

2 The enlarged Single Market has become, despite the increased economic divergence since the

0

BG C Y C Z EE HU LT LV MT PL RO SI SK NMSO MS 2004 enlargement among its current members,

more integrated and dynamic (European

Note: BG, RO: no data available

Source: Eurostat (Structural Indicators) Commission, 2006a). At the same time, EU

accession has played a role in the rapid increase

Latvia managed to attain the position of the most of trade openness in the new Member States.

open public procurement market in the whole EU Owing to a significant lowering of real trade

(13.8% of GDP in 2006 compared to 1.8% in costs as a result from the further trade

2004), but also Estonia (7.3% in 2006 compared liberalisation (including tariffs, antidumping

to 2.7% in 2004) and Hungary (6.8% in 2006 proceedings and other non-tariff barriers) intracompared

to 1.3% in 2004) displayed significant EU trade and FDI flows have increased

progress. Access to the Maltese market is significantly.

particularly difficult. Openly advertised public

procurement started in 2004 at the lowest level 1.3.1. Mergers and acquisitions

within the EU as a whole (0.2%) and attained

only 1.8% of GDP in 2006. These are, however, Cross-border mergers and acquisitions (M&A) provisional findings which have to be treated generally represent the major part of FDI. They with caution. The amount of data so far available essentially imply a pooling of assets or a is limited and might affect the reliability of the reallocation of corporate control, through which figures for the smaller of the new Member firms want to achieve certain strategic goals. The

States ( 69 ). motivations behind mergers may be very diverse, ranging from efficiency considerations and cost

saving to firm-expansion or market access.

1.3. IMPACT OF ENLARGEMENT ON THE Framework conditions, such as specific policies

SINGLE MARKET or the level of economic integration between countries obviously also affect the incidence of

The recent accession of twelve new Member individual M&A, for example by influencing the States substantially increased the size of the decision between market entry through trade or Single Market, while constituting at the same direct investment in the form of an acquisition. time a challenge to its proper functioning. On the The effects of mergers may also be diverse and one hand, the accession of the Central and consequential, ranging from technological Eastern European countries has increased the spillovers to increased innovation, thus pool of consumers and has provided firms with ultimately affecting economic performance.

( 69 ) In addition, the regulations covering the structural funds

ensure that procurement with EU funds will appear as openly advertised. This may show up as a spike in the period (2004-2006) particularly since 2004 data is only for the six months after accession.

Chapter VII

Enlargement and the EU policy framework

Table VII.1.1: Mergers and acquisitions in the new and old Member States classified by region of bidding firm, 2000-2007

New Member States 2000 2001 2002 2003 2004 2005 2006 2007

Number of deals 1487 1131 828 821 561 687 746 895 of which (in %):

Domestic 48.6 52.3 47.5 50.5 41.5 36.7 36.1 39.0 NMS 3.2 2.6 5.7 4.8 8.0 5.7 5.6 8.7 OMS 33.8 34.8 32.7 29.6 30.8 40.8 42.0 35.2 US 6.3 4.6 4.5 4.5 6.4 7.6 6.3 7.4 Asia 0.2 0.2 1.0 0.4 0.9 1.0 1.3 1.3 ROW 7.9 5.5 8.7 10.2 12.3 8.3 8.7 8.4

Value (€ Bn.) 19.3 19.5 16.2 7.4 15.3 28.4 20.7 36.1 Old Member states

2000 2001 2002 2003 2004 2005 2006 2007 Number of deals 13208 10148 7837 8083 8527 8937 10283 10887 of which (in %):

Domestic 68.9 69.0 70.5 70.5 69.2 65.8 66.3 64.6 NMS 0.1 0.3 0.2 0.1 0.3 0.2 0.3 0.4 OMS 19.2 18.5 16.5 15.0 15.0 17.2 16.7 18.5 US 6.5 5.9 6.1 6.8 8.0 7.7 7.5 7.3 Asia 0.6 0.8 1.0 0.9 1.1 1.7 1.4 1.5 ROW 4.6 5.5 5.7 6.6 6.4 7.4 7.8 7.7

Value (€ Bn.) 1072.7 561.8 452.4 390.2 537.9 696.7 873.5 1127.0

Source: Thomson Reuters, Commission services

The examination of the evolution of mergers and elsewhere in the world accounted for 17% of acquisitions since 2000, in which firms from the acquisitions only, a combined share that is new Member States have been targeted shows comparable for new and old Member States. that the number and aggregate value of M&A in Within the new Member States, most M&A the new Member States have been steadily targets were located in Poland, the Czech increasing over the past four years, after a Republic, Hungary and Romania. contraction following the global M&A wave, which reached its crest in the year 2000 (Table The patterns of cross-border acquisition initiated VII.1.1). This development is similar in the old by the new and old Member States also differ Member States, even if the frequency and considerably. Firms from the old Member States aggregate value of M&A in the new Member invest more in the USA or in Asia, while firms in States only represents a fraction compared to the the new Member States focus on markets that are old Member States. located closer to them.

While an enlargement effect is hard to identify The distinction between cross-border M&A deals prima facie, a decomposition of bidders by and domestic deals reveals that for cross-border region of origin reveals interesting differences deals, manufacturing is the most targeted sector between the old and the new Member States. in both the new and the old Member States, Indeed, while around two thirds of M&A in the accounting for 34% to 36% respectively (Table old Member States were domestic deals, the VII.1.2). A striking difference, however, is the majority of acquisitions in the new Member relatively low share of cross-border acquisitions States are made by foreign buyers. For crossin the services sectors in the new Member States border deals, the predominance of investors (43%) compared to the EU-15. That said, within located in other EU countries is obvious: in the services sector the share of the finance, 2007, in addition to domestic deals which insurance and real estate sector is significantly represented 39% of M&A in the new Member higher in the new (20.5%) than in the old States, 35% were targeted by firms located in an Member States (about 12%). The same is true for EU-15 country, while in around 9% of cases the network industries, even though the new bidding firm was located in another new Member Member States' share is slightly lower (17%). As State. Deals originating in the USA, Asia or far as domestic deals are concerned, the main

European Commission

Five years of an enlarged EU

Table VII.1.2: Sectoral classification of mergers and acquisitions in old and new Member States, 1998-2007

Cross-border deals Domestic deals As % of total number of deals NMS OMS EU-27 NMS OMS EU-27 Agriculture, Forestry and Fishing 1.1 0.4 0.5 1.3 0.7 0.7 Mining 2.6 1.2 1.4 2.0 1.1 1.1 Construction 2.9 1.9 2.1 3.6 2.9 3.0 Manufacturing 33.9 35.7 35.4 36.5 28.4 28.8 Network industries 16.7 11.7 12.5 14.0 10.5 10.7 Services 42.9 49.1 48.1 42.6 56.5 55.7

of which: Wholesale Trade 4.8 6.9 6.6 4.6 5.8 5.7 Retail Trade 3.6 4.0 3.9 5.3 6.4 6.3 Finance, Insurance and Real Estate 20.5 12.4 13.8 15.8 15.3 15.3 Other Services 13.9 25.7 23.6 16.9 28.9 28.2 Public Administration 0.1 0.1 0.1 0.1 0.2 0.2

Number of deals 3585 17059 20644 4072 65905 69977

Source: Thomson Reuters, Commission services

target sector in new Member States is Graph VII.1.4: Price convergence between EU Member States manufacturing (36.5%). The services sector is 45 Coe fficie nt of variation of comparative price le ve ls of much less targeted in new Member States (43%) final consumption by private house holds including

than in the old Member States (57%). 40 indire ct taxe s (%)

35

1.3.2. Price convergence 30

EU-27

The increased integration brought about by the 25 O MS

Single Market is also expected to accelerate price 20 convergence among EU Member States. This 15

tendency is reflected in graph VII.1.4. which 10

shows that the coefficient of variation of

comparative price levels of final consumption 5

(including indirect taxes) across the old Member 0 States has decreased from 14.7% in 1996 to 96 97 98 99 00 01 02 03 04 05 06 07 12.6% in 2007. In the EU-27 progress has been Source: Eurostat (Structural Indicators) even more remarkable as the new Member States

become increasingly integrated with the rest of The examination of the variation in price the EU and progressively adopt the Single levels ( 70 ) over the 1996-2007 period shows that Market acquis. For the EU-27 the coefficient of across most high income old Member States price variation dropped from 40.9% in 1996 to inflation levels have declined and price levels 26.2% in 2007. converged downwards towards the EU-27

average (Graph VII.1.5.). This can be partially

However, the enlargement of the Single Market attributed to the Single Market which played an to countries characterised by lower income per important role in the downward pressure exerted capita than that of the old Member States has on prices as it allowed for tougher competition in

generated two opposing forces simultaneously product and factor markets across the EU.

influencing the process of price convergence. On the one hand, the rise in competition in the Single Market exerts downward pressure on prices due to lower mark-ups of prices over marginal costs. On the other hand, the catchingup process of low income economies leads to a rise in the price levels and higher inflation over a transition period. The overall price level then tends to increase and affects the consumption

and production pattern of the economies. (

70

) The variation in price levels is the difference in the comparative price levels between 1995 and 2007.

Chapter VII

Enlargement and the EU policy framework

Graph VII.1.5: Price convergence: Comparative changes in price levels over time, 1996-2007

RO LT SK IE LV EE HU UK CZ BG PL M T SI IT EL ES PT CY DK LU NL BE FI FR DE

(EU-27 ave rage = 0) AT SE

-20 -10 0 10 20 30 40

Source: Eurostat

In the new Member States and in lower income old Member States price levels have converged upwards towards the EU-27 average. While integration and competition enhancing reforms have had disciplinary effects on firms' pricing strategies, the increased trade with higher income economies, improved production quality and the

Balassa-Samuelson effect associated with the income convergence have pushed price levels up.

Both competition and catching-up effects are taking place at the level of new Member States

(Dreger et al., 2007). While catching-up appears to be the dominant effect, leading to an upwards convergence of prices, competition appears to have a dampening effect on the overall price increases (Box VII.1.1.).

European Commission

Five years of an enlarged EU

Box VII.1.1: Examining price convergence in the enlarged Single Market

Dreger et al. (2007) examined whether price When disentangling the catching-up and

convergence in the enlarged Single Market will 2 competition effects ( ) on price convergence, the

occur through upward price trends in the new study found that both are important elements in Member States or downward trends in some of explaining convergence for the new Member the old Member States. The examination of β- States. The catching-up effect had a significant (convergence towards the mean) and σ- impact on price levels both when analysing the convergence (reduction in price dispersion over overall sample and individual product categories. time) confirmed the occurrence of price While competition (measured by import convergence in the enlarged Single Market. penetration and the amount of price control However, differences were found according to regulation present in the economy) has a the homogeneity/differentiation of the products significant effect on price levels in the overall under consideration, as well as according to their sample, its impact on the prices of individual tradability. Price convergence was found to be product categories is unclear as it depends on the stronger in the case of more homogenous variable used to measure it. In this sense, import products and weaker when more differentiated penetration was found to be significant in the products were analysed. In addition, the speed of case of semi-durables, durables and equipment convergence increases with the tradability of the goods, while price controls were found to be

1

product. As a result ( ), the half life of shocks, significant in services and equipment goods. which measures the number of years it takes for a shock of one unit to decrease by 50%, decreases In the old Member States, the catching-up effect with the tradability of the product. For example, is only significant when examining more shocks are expected to be removed by 50 percent homogenous price categories, but not in the case after 2.1 years in the case of durables (the more of more differentiated products. The significance tradable products), compared to 3.7 years for non of the competition effect on price levels depends durable goods. It takes even longer for non on the variable used to measure it. If higher tradables, such as services and buildings. The competition is captured by a reduction in price study also found that a significant decline in price controls, then it has a significant impact on prices dispersion over time can be detected for both the for most product categories. If higher competition new Member States and the old Member States. is captured by an increase in import penetration, then it has a significant impact on prices only for non-durable goods.

( 1 ) The half life of a shock is calculated as

ln 0 . 5

t * = − where λ is the speed of convergence. ( 2 ) Principal component analysis is applied to per capita λ income, productivity and wages. The common

information extracted from these variables in the first principle component is interpreted as measuring the catching-up effect. The competition effect is measured by import penetration and the strength of business regulation as captured by the Fraser price control sub-indicator. The higher the degree of import penetration ratio, the higher the competition pressure exerted by the Single Market. The higher the price control indicator, the higher the degree of deregulation in the economy and therefore the

stronger the competition pressure.

• 2. 

  THE LISBON STRATEGY FOR GROWTH AND JOBS

This section focuses on the Lisbon process – a and focused on issues such as: the existence of comprehensive strategy for the coordination of an enforceable legal system, including property structural reforms in the EU – and analyses the rights; the existence of a well-developed participation of the new Member States in that financial sector and the absence of any process. This section starts by reviewing the significant barriers to market entry and exit; the process of structural reform in the new Member availability of a sufficient amount of human and States before and after the enlargement, and physical capital, including infrastructure; argues that the prospect of EU membership has restructuring of enterprises; and access of played an important role in implementing wideenterprises to outside finance. These priorities ranging structural changes in these countries. It were translated into the pre-accession then focuses on the procedural aspects of partnerships, which specified a number of participation in the Lisbon strategy and discusses country-specific reforms. The progress was then the impact they have had on the domestic policyregularly monitored and assessed in the annual making in the area of structural reforms. The reports by the Commission. third subsection provides a forward-looking comparative analysis of the reform priorities in As a result of their efforts to fulfil the economic both old and new Member States. The fourth accession criteria, the candidate countries rapidly subsection provides a snapshot of the progress converged towards the old Member States in achieved since the relaunch of the Strategy in terms of the regulation of product, labour and 2005 and the fifth subsection presents some financial markets. The improvements in the conclusions. regulatory set-up can be discerned in a number of

existing regulatory indexes (such as the OECD product market regulation index or employment

2.1. NEW MEMBER STATES AND STRUCTURAL protection legislation index, World Bank ‘Doing REFORM Business data’ or EBRD transition indicators). As an example, graph VII.2.1 shows the

2.1.1. Pre-accession reforms evolution of the Fraser index of regulation in

product, labour and capital markets, which does The new Member States have a significant indeed document the fast regulatory convergence reform record: as countries that transformed their with the EU-15 levels by the new Member States

economies from a centrally planned to a fully ( 71 ).

market-based model, they implemented

substantial structural reforms prior to joining the 2.1.2. Does reform fatigue inevitably follow EU. Following the initial macroeconomic enlargement?

stabilisation, liberalisation of prices, trade and investment flows, and privatisation of large parts Despite significant progress in the pre-accession of the economy, a gradual process of structural phase, there still remains considerable scope for reform began, encompassing virtually all sectors, reform in the new Member States (see the with the emphasis on introducing a modern and discussion in section 2.3). Nevertheless, some well-functioning institutional framework that would allow dynamic and sustained convergence towards developed economies.

The conditionality of EU membership worked as

a powerful incentive for the implementation of (

71

) It should be noted that the Fraser index is just one of

numerous structural measures (Grabbe, 1999). In many indicators which measure progress in regulatory reform. As most of the other measures it can be subject

particular, the emphasis of the economic to criticism due to its limited coverage of different

accession criterion on the existence of fullyaspects of regulation. Nevertheless, given its broad

fledged functioning and competitive market country coverage and long time span it can be used for documenting the regulatory trends during the transition

economy was particularly relevant. This criterion in comparison with other economies. The results should was spelled out in greater detail in the be considered with caution though. For the sake of

Commission Communication on Agenda 2000 robustness of the analysis, alternative measures are analysed further in the text.

European Commission

Five years of an enlarged EU

Graph VII.2.1: Fraser index of regulation in product, labour and financial markets

10 Fraser index 0.25 average 95-00 00-04 2006 index 10

change

9 04-06 Index 06 level 9

0.20

8 8

7 7 0.15 6 6

5 0.10 5 EU-10

4

4 BG, RO

0.05 3

3 OMS

2

2 0.00

Developed 1 1 countries

-0.05 0

0 EU-10 BG-RO OMS Developed

90 95 00 04 06 economies

Note: The values of the index lie in the range (0,10) with higher one indicating more business friendly levels of regulation. (2) Developed countries include: Australia, Canada, Hong Kong, Iceland, Israel, Japan, New Zealand, Norway, Singapore, Switzerland, United States Source: Fraser Institute (www.freetheworld.com)

observers ( 72 ) have suggested that the accession entry approached (Graph VII.2.1, right panel)

to the EU has coincided with a phase of "reform and fell back thereafter. In addition, the reform fatigue", where the efforts of Member States to efforts generally increased substantially in the reform their economies are reduced. Reasons for year of accession – 2004. The pre-accession this my include the weakened incentive for reform effect is also visible in the case of the two reform, the need to fully absorb the impact of countries (Bulgaria and Romania) that joined the past reforms and the exhaustion of the political EU two years later, in 2007. Nevertheless, the capital needed to push ahead with further reform intensity of the improvements in these areas in

efforts( 73 ). the new Member States has remained significant

and is still higher than in the EU-15 countries. The available reform indicators showing the level of stringency of the existing market Various reform indicators for the individual institutions, the quality of their enforcement and reform areas generally support these aggregate the resulting impact on the operation of the conclusions, although a more nuanced picture economy can provide an indication as to the does appear (Table VII.2.1). In product markets, possible existence of "reform fatigue". most of the reform indexes point to a slowdown

of reform in the new Member States as a whole For example, looking at the Fraser index of after 2004, both in absolute terms and relative to aggregate regulation in credit, labour and product the old Member States. In financial markets, the markets, which reflects the outcomes of reforms available indexes provide mixed messages, with in terms of more business-friendly markets, the the Fraser sub-index for capital markets pointing significant impact of enlargement is documented at an absolute (as well as a relative) slowdown, by the fact that the pace of reform efforts picked and the EBRD transition indexes not showing an up noticeably in some areas as the date of EU absolute reduction in reforms. In labour markets,

the Fraser sub-index for the labour market shows that the relative pace of reforms dropped after 2004 (but not the absolute), although the

( 72 ) For example, Financial Times, 27 September 2006,

"Reform fatigue has hit the east" by Stefan Wagstyl and evidence from more detailed labour market

Christopher Condon. indicators is inconclusive.

( 73 ) It is nevertheless important to define clearly what reform

fatigue is. Due to very high reform efforts prior to accession, a consequent decline can just be a statistical "base effect". It is, therefore, useful to compare the reform intensity with that in a reference group to be able to judge whether a decline in reform activity is to be considered a potential cause of concern.

Chapter VII

Enlargement and the EU policy framework

Table VII.2.1: Evidence on post-enlargement reform fatigue form different reform indicators

Was there an absolute slowdown in reforms after 2004? CY CZ EE HU LV LT MT PL SK SI BG RO NMS YES NO

Fraser index - Product markets na no no no no no na no no no no no no 0 10 Heritage Business Freedom Index yes no yes no no no yes yes yes yes no no yes 6 6

World Bank - Quality of regulation yes yes yes yes yes yes yes no yes yes yes no yes 10 2 EBRD TI - Enterprise restructuring na no no no yes yes na no no yes yes no yes 4 6

EBRD TI - Competition policy na yes no no yes no na no no no no no no 2 8 EBRD TI - Infrastructure reform na yes no no yes no na no yes yes yes no yes 5 5

OECD Product market regulation na yes na no na na na yes na na na na yes 2 1 Fraser index - Capital market yes yes yes no no yes yes yes no yes yes yes yes 9 3

EBRD TI - Banking reform na yes no no yes no na no no no no no no 2 8 EBRD TI - Securities markets na no no no yes no na no yes no no yes no 3 7

Fraser index - Labour market na no yes no no no na no yes no no no no 2 8 Tax rate on low wage earners no no no yes yes yes yes yes no yes no yes no 7 5

OECD EPL regular na no na yes na na na no yes na na na yes 2 2 OECD EPL temporary na yes na no na na na yes yes na na na yes 3 1

Unemployment trap na no na yes na na na no no na na na yes 1 3 Inactivity trap na no na yes na na na no no na na na no 1 4

Was there a slowdown in reforms relative to the OMS? CY CZ EE HU LV LT MT PL SK SI BG RO NMS YES NO

Fraser index - Product markets na yes yes yes yes no na no yes no yes yes yes 7 3 Heritage Business Freedom Index yes yes yes yes yes no yes yes yes yes no no yes 9 3

World Bank - Quality of regulation no yes no yes yes yes yes no yes yes yes no yes 8 4 OECD Product market regulation na yes na no na na na yes na na na na no 2 1

Fraser index - Capital market yes yes yes no no yes yes yes no yes yes yes yes 9 3 Fraser index - Labour market na no yes yes yes yes na no yes yes no no yes 6 4

Tax rate on low wage earners no no no yes no yes no no no yes no no no 3 9 OECD EPL regular na no na no na na na no yes na na na no 1 3

OECD EPL temporary na yes na no na na na yes yes na na na yes 3 1 Unemployment trap na no na yes na na na yes no na na na yes 8 4

Inactivity trap na no na yes na na na no no na na na no 3 7

Note: The table compares annual changes in normalised reform indexes for periods 2000-2004 and 2004-2006 (1998-2003 and 2003-2006/8 for

OECD indexes). For the comparison with the old Member States, a simple average of available EU-15 countries is taken as a benchmark. Counts of "yes" and "no" include only individual new Member States and not the EU-10 aggregate.

Source: Fraser Institute, Heritage Foundation, World Bank, EBRD, OECD, Eurostat.

Alternatively, it is possible to explore the extent Consequently, there remains a significant need to of the reform activity of governments and move the structural reform process forward in administrations by looking at the number of order to sustain the catching up process and to reform measures implemented. Thus, box VII.2.1 boost the adjustment capacity and explores the number of reforms in the EU labour competitiveness of the new Member States. markets over the period 2000-2006 using econometric techniques. It concludes that the The old Member States largely face the same legislative activity of governments in new challenge. As Graph VII.2.1 indicates that there Member States increased in comparison with the is still considerable room for improving old Member States. This result may be explained regulation to make it more business-friendly in by the fact that the proliferation of reforms in the the EU compared to other developed countries. post-enlargement period was due to the adoption This should help markets to operate smoothly of a number of measures as a follow-up to the and flexibly in view of the rapidly changing substantial reforms implemented in the run-up to world economic climate, and all the more so EU membership. since the recent financial crisis. Hence, both new

and old Member States face the same need for

2.1.3. Looking ahead reform, as well as political constraints that are

hampering faster progress in implementing the While the new Member States made considerable necessary structural reforms. The need to adjust progress in the pre-accession period and met the quickly is now particularly pressing, as the Copenhagen economic criterion, many important consequences of the financial crisis have spilled structural reforms that were on the agenda of the over into the real economy and are leading to a governments have lagged behind (e.g. pension sharp deterioration in both current and forecast reforms, conditions for starting a business, growth rates across the whole of the EU. modernising bankruptcy legislation, reforms of national innovation systems, education reform).

European Commission

Five years of an enlarged EU

Box VII.2.1: Was there a reform fatigue in the new Member States after enlargement?

This box analyses whether accession coincided number of reforms per year between the new with a new phase of 'reform fatigue', where the Member States (including Bulgaria and Romania) efforts by Member States to reform their and the EU-15 countries. Although in all years economies are reduced as a result of weakened reforms appear less frequent on average in new incentives and the need to fully assimilate the Member States, the frequency of reforms has impact of past reforms. been rising since 2000 in comparison with the old Member States. Most of the increase is due to With a view to address the above question for higher reform activity in new Member States, what concerns labour market reforms, analysis while the average number of reforms across EU- has been conducted on the DG ECFIN labour 15 countries was broadly constant (ranging from reform LABREF database. LABREF is one of the a minimum of 9.12 reforms in 2002 to a few sources of comparable information on maximum of 12.6 reforms in 2004). reforms in all Member States. The database provides a comprehensive description of The second problem with the definition of an legislation changes in all EU Member States in appropriate counter-factual is that the need to the field of labour market regulation, labour reform labour markets may vary across countries taxation, pensions. To date, the database covers and time periods, as well as the extent to which the 2000-2006 period. feasibility constraints are binding. To control for these additional factors regression analysis is Assessing whether reform fatigue is taking place needed. To this end, the number of reforms in new Member States involves the difficulty of taking place in each country and each year is defining an adequate counter-factual. regressed against a series of explanatory factors and country-specific effects capturing labour First of all, looking at whether reforms became market conditions in each country at the more or less frequent in this group of countries beginning of the sample (IMF, 2004; Buti, after enlargement may not be sufficient, since the Roeger and Turrini, 2008; J. Hoj et al. 2004). The variation in the reform effort over time could be econometric specification also includes a dummy driven by factors common to all countries. variable capturing a common new-Member States effect, a dummy capturing effects common In this respect, it is helpful to resort to a to all countries in the sample following the 2004 'difference-in-difference' approach, whereby enlargement, and a dummy capturing uniquely changes the reform effort in the new Member post-enlargement effects for the new Member States are assessed against a 'control' group of States. The presence of a possible reform fatigue countries. Graph 1 provides such an assessment would be revealed by the sign of this last using the old Member States as a control group. variable. The graph reports the difference in the average

Graph 1: Frequency of labour market reforms in new versus old Member States, 2000-2006

1.5 0

1.0 -1

0.5 -2

0.0 -3

-0.5 -4

-1.0 -5

-1.5 -6

-2.0 -7 00 01 02 03 04 05 06

Labour taxation Une mplome n t be ne fi ts ALMP EPL Pe nsion syste m Wage bargaini ng W orki ng tim e Im migration-mobili ty Total (right axis)

Source: Commission services

(Continued on the next page) Chapter VII

Enlargement and the EU policy framework

Box (continued)

Table 1: Econometric analysis of reform determinants

Dependent variable (number of reforms per year)

Explanatory variable Total reforms Reforms in labour Reforms in Other reforms affecting taxation pension systems labour supply and demand

Lagged number of reforms in the same -0.013* -0.07 -0.170*** -0.016 area (-1.82) (-1.32) (-3.80) (-1.47)

Lagged NAWRU 0.102** 0.313** 0.036 0.072 -2.5 -2.56 -0.37 -1.5 Change in employment rate -0.112** 0.026 -0.320** -0.116 (-2.32) -0.21 (-2.22) (-2.06) Lagged output gap -0.047 -0.202** -0.044 -0.014 (-1.60) (-2.49) (-0.51) (-0.42)

Lagged change in primary cyclically-0.001 -0.114** -0.055 0.032 adjusted budget balances (-0.04) (-2.23) (-1.15) -1.41

New Member States (dummy) -1.659*** -6.156*** -0.883 -1.168*** (-5.52) (-4.36) (-0.81) (-3.45) Post enlargement period (dummy) 0.088 -0.235 -0.059 0.218* -0.93 (-0.95) (-0.24) -1.92

New Member States after enlargement 0.466*** 1.284*** 0.589 0.306* (dummy) -3.32 -3.11 -1.56 -1.86 Number of observations 144 144 144 144 Note: Estimation method: Poisson regressions. All regressions include (unreported) country fixed effects. Regression coefficients represent the impact of a unitary increase of each of the explanatory variables on the logarithm of the number of reforms per year. Z statistics are reported in parentheses. *, **, *** denote, respectively, coefficients significant at the 10, 5, 1 per cent level of significance. The New Member States dummy takes value 1 for all New Member Sates that entered the in 2004 and 2007. The enlargement dummy takes value 1 after 2003. Source: AMECO and LABREF

The regression results indicate that past reforms taxation, however, appear to be hampered by an appear to reduce the likelihood of additional ongoing fiscal consolidation effort. Moreover, measures. As expected, reforms appear to be the increase in the frequency of reforms in New more frequent when the NAWRU (Non Member States in the post-enlargement period is Accelerating Wage Rate of Unemployment) is not statistically significant as far as pension high, cyclical conditions are weak, and reforms are concerned. Although it is important employment rates are falling. The fiscal stance to interpret results with caution (the number of has no significant impact on the frequency of legislation changes enacted is not necessarily reforms. New Member States exhibit a lower representative of the extent to which the actual frequency of reforms, which however rises after functioning of labour markets is modified) the enlargement. Repeating the same regression data appear to reject the hypothesis of a postusing, as alternative dependent variables, reforms enlargement reform fatigue phenomenon in new in labour taxation, in pension systems, and in Member States. remaining legislations affecting labour markets, results are broadly confirmed. Reforms, in labour

pressures due to globalisation, the accelerating 2.2. LISBON STRATEGY AND NEW MEMBER pace of technological change, and the

STATES implications of ageing populations for potential growth and public finances. Structural reforms

The Lisbon strategy is a comprehensive strategy are also needed as a part of the response to the for reform launched by the European Council in implications of the international financial crisis March 2000. The aims of the strategy are to for the real economy, as they help boost coordinate and stimulate structural reforms in the confidence, facilitate transitions within and into areas of macroeconomic policies, labour, product the labour market in the short and medium term and financial markets with the objective of and increase potential growth in the long term. modernising the European economy and Structural reforms have therefore a crucial role to promoting its innovation capacity. This was play in the European Economic Recovery deemed necessary if Europe is to successfully face the challenges of increasing competitive

European Commission

Five years of an enlarged EU

Plan ( 74 ), which is the EU's response to the EU membership acted as a powerful incentive to

economic and financial market crisis and which implement the necessary reforms (or, equally, the has been proposed by the European Commission threat of postponed membership in the case of in November 2008 and agreed in the European non-compliance acted as a potential but effective Council in December 2008. sanction), the Lisbon agenda is essentially a political process relying on the political The strategy is an integral part of the policy commitment of Member States to effectively coordination framework established by Articles deliver on their reform promises. On the other 99 and 128 of the Treaty. It relies on headline hand, after accession, the need for structural targets, guidelines, multilateral surveillance, peer reforms is underpinned by other objectives too. review and benchmarking. These are "soft" tools For example, an increased capacity to effectively whose aim is to build consensus and exchange of absorb EU funds also depends on further experiences. To guide reforms at national level, structural reforms aimed at easing supply the EU issues "country-specific constraints, and the objective of joining the euro recommendations" (identifying specific pressing area requires a further improvement in the issues that require policy action) and "points-tofunctioning of the markets for labour, products watch" (pointing to issues which require and finance. These objectives thus strengthen the increased attention and potentially policy action). incentives of the new Member States to carry out

These measures, however, rely on a political the necessary structural reform. commitment only and are not legally binding. With respect to the governance of the strategy, Following a mid-term review in 2004-5, and the 2004 enlargement has had important based on the unsatisfactory progress in implications, which impact in their turn on the implementing the necessary structural reforms, conditions for the implementation of structural the Lisbon strategy was relaunched. First, it was reforms in the new Member States. In particular, decided that the efforts had to concentrate more it has compounded the diversity between on promoting growth and generating jobs. Member States in terms of their structural Secondly, a streamlined governance structure conditions and the related need for reforms. The was agreed which, besides establishing a more new Member States are all “catching-up” integrated approach and delineating more clearly economies, with comparatively large technology the responsibilities at national and EU levels, gaps compared to most of the old Member also increased the political prominence of the States. This fact accentuates the diversity in the strategy as a means of improving the EU and, as a consequence, the need for enforceability of reform commitments made by flexibility and a country specific approach has national governments. The renewed Strategy was increased. The answer was to place the emphasis endorsed by the European Council in March on ownership of reforms, which is reflected in 2005. the Member States' responsibilities when setting their national reform agendas and which provides The participation of the new Member States in enough flexibility to accommodate specific the Lisbon strategy has a dual impact. On the one national conditions. hand, the Lisbon strategy provides new Member States with a different framework and different This puts the emphasis on the ability of incentives for conducting reforms. On the other administrations to draw up realistic, yet hand, enlargement has implications for the appropriately ambitious, reform plans and to governance of the strategy itself. carry them out. The EU Integrated Guidelines – a blueprint for policy approaches – set common Regarding the incentives for reforms, compared objectives, priority actions and targets. However, to the pre-accession period when the prospect of given the diversity among the EU Member States and the fact that structural reforms fall largely within the remit of national governments (the

( 74 ) Commission Communication "A European Economic EU's internal market being a notable exception),

Recovery Plan", COM(2008)800 i Member States can choose various policy

approaches at national level in order to achieve

Chapter VII

Enlargement and the EU policy framework

these objectives. In order to succeed, it is or underperformance in relation to the EU-15

essential to identify the correct policy priorities benchmark( 75 ).

and translate them into a coherent reform strategy. There is thus a need for robust analysis Graph VII.2.2: Share of Member States underperforming in a

that should underpin the choice of reform policy area

priorities and the design of concrete reform S ustai nabi l ity of pu bli c fi nance s macro pil l ar measures so as to maximise their effectiveness in C ompe ti ti on pol i cy frame work

the national context. Robust and transparent Educati on and l ife long le arn in g

analysis is also essential to sustain the credibility NMS of country-specific recommendations issued to IC T O MS

Member States. Such recommendations need to R&D and In novation

be relevant and underpinned by an analysis Marke t i nte gration

which is comparable across countries, policy Fi nan cial marke ts and acce ss to mi cro pil l ar fin ance

areas and time. Moreover, cross-country Busi ne ss Dynami cs

comparative analysis facilitates peer review, Busi ne ss e nvi ronme n t

sharing of best practices and mutual learning. Se ctor spe ci fi c re gu lati on (te le com,

e n e rgy)

ALMPs

Labour marke t mi smatch an d

2.3. THE REFORM PRIORITIES IN THE NEW l abou r mobi l ity

AND OLD MEMBER STATES Immi grati on and i nte gration pol i ci e s

W age bargai ni ng and wage -se ttin g poli ci e s

In its effort to underpin the Lisbon process with a Labou r supply me asure s for ol de rrobust

 analytical basis, the Commission is worke rs

e mpl oyme nt pi ll ar

Labour suppl y me asure s for wome n

working on methodologies for the monitoring

and evaluation of the Lisbon reforms. Incre asi ng work in g ti me

Monitoring and assessing reforms is an important Job prote ction factor in the success of the Lisbon strategy. In Labour taxation addition, analysis of underperforming policy Maki ng work -pay areas can help Member States identify their 0 % 2 0 % 4 0 % 6 0 % 8 0 % 10 0 %

reform priorities. The analysis in this section Source: Commission services

draws on an analytical framework developed by the Commission services on the basis of a

method agreed with the Member States (Box Overall, the results show a significant degree of

VII.2.2). heterogeneity among the EU-27 countries (Graph VII.2.2). On average, nevertheless, the new

Member States underperform in more policy

2.3.1. Underperforming policy areas areas than the old ones. Compared to the EU-15

In order to explore the policy priorities that countries, the new Member States lag behind to a would help Member States to achieve the far greater extent in the area of knowledge and headline Lisbon goals, i.e. higher growth and innovation and also to some extent in product more jobs, the performance in a number of and capital markets, i.e. areas that are crucial for relevant policy areas is assessed. A total of 20 the long-term productivity growth. In terms of policy areas falling under the three broad areas of concrete policy areas, poor results are more the Lisbon strategy (macro, micro and prevalent in R&D and innovation, ICT, employment) are analysed. These areas are education and life-long learning, competition

generally those which the economic literature has identified as being relevant for GDP growth. The

analysis indicates whether a policy area is (

75

) As explained in Box VII.2.2, this assessment rests on

exhibiting overperformance, neutral performance indicator-based analysis (for each policy area an aggregate score is derived from the performance in

selected indicators) which is complemented with additional country-specific evidence and qualifications. When interpreting the results it also needs to be borne in mind that this is a relative assessment and a change in the benchmark could alter the conclusions.

European Commission

Five years of an enlarged EU

policy framework, and financial markets in the important to avoid complacency and to address new Member States. They also underperform the existing shortages, which could become a

significantly more often in some areas in the serious obstacle to future growth. employment field, namely ALMPs, specific labour supply measures for women, labour As regards the differences in the level of market mismatch and labour mobility. contribution to GDP from labour utilisation, the new Member States generally outperform the old Underperformance in the old Member States ones (sometimes by a large margin). This is seems to be more concentrated in policy areas consistent with the relatively better performance associated with the labour market, in particular in of the new Member States in the labour market the areas of labour taxation, job protection, areas compared to the EU-15 benchmark (to a policies to increase working time, immigration large extent in terms of average hours worked). and integration policies. In the micro field, However, in terms of growth, the contribution of sectoral regulation seems to be the area where labour utilisation overall was slightly negative. most old Member States are lagging behind in Yet there was a considerable improvement in the terms of performance. It is also noteworthy that post-enlargement period, and the acceleration in almost half of the old Member States overall growth in 2004-2006 was also due to a underperform in the area of R&D and better labour market performance. innovation. Consequently, the area of knowledge

and innovation seems to be one where there is 2.3.2. Magnitude of the challenges

important room for improvement in all EU countries, although underperformance in the new While the previous section analysed the Member States is more acute than in the old distribution of underperforming policy areas ones. across new and old Member States it is also interesting to explore whether the challenges are The general picture of underperformance in greater for the former than for the latter. This can policy areas is consistent with the pattern of be done by analysing the aggregate scores for performance in terms of the differences in GDP individual policy areas which indicate the extent level and growth. This in turn indicates that the of over- or underperformance (Graph VII.2.3) identified weaknesses may be acting as and thereby the magnitude of challenges faced

bottlenecks to growth and that tackling them by countries( 76 ).

could be effective in boosting growth and employment performance. In most of the policy areas related to the labour markets, the performance of the new Member The new Member States, as catching-up States does not differ substantially from that of economies, often post considerably lower levels the old ones. However, there are two notable of GDP per capita than older Member States: exceptions: the performance of the new Member average GDP per capita in new Member States is States seems, on average, to be considerably around half that of the old Member States. This weaker in terms of ALMPs, while the old considerable differential vis-à-vis the old Member States experience greater problems in Member States is mainly due to weak respect of policies that increase working time. In productivity levels, which are the main concern addition, wage setting policies warrant attention in all new Member States. This can largely be in Bulgaria and Romania, as unless the recent linked to the lower level of technological high increases in wages prove to be only development and the weaknesses that remain in temporary, they may threaten the some micro policy areas. It has to be realised, competitiveness of these economies. however, that progress has been considerable. Due to advances in enterprise restructuring and privatisation, improvements in the business environment, increases in FDI inflows and

transfers of technologies, it is the growth in (

76

) Note that average aggregate scores for policy areas are

labour productivity that has been the main driver computed for the EU-15, the EU-10 as well as Bulgaria and Romania (considered as a specific group for this

of the catching up process. Nevertheless, it is exercise).

Chapter VII

Enlargement and the EU policy framework

Box VII.2.2: An assessment framework for structural reforms

The Commission services developed in To avoid giving too much weight to outliers, the

collaboration with Member States ( 1 ) an score is capped at three standard deviations. Thus

analytical tool called the "LIME Assessment scores range from +30 to -30. Standardised Framework" (LAF). This framework can help thresholds have also been used to determine underpin the assessment with respect to categories of performance. A score below – 4 is a identification of key policy challenges in raising priori considered to represent underperformance growth potential and also, to some extent, past (-); a score between +4 and -4 is a priori performance in implementing structural reforms. considered to represent a neutral performance (=); a score above +4 is a priori considered to The framework builds on an examination of the represent over-performance (+). The overall sources of GDP per capita differentials and the assessment of performance is reached by main drivers of growth relative to a benchmark combining the results of the indicator-based (EU-15 average). This is done through a GDP per assessment with additional country-specific capita decomposition, both in level (in 2006) and evidence and qualifications. in changes (over the period 2000-2006) into a

number of GDP components( 2 ). This framework provides a consistent and

transparent tool for examining performance Furthermore, an analysis of performance is across many policy areas in the Lisbon process, carried out in 20 policy areas which the economic taking account of both levels and changes. It can literature has identified as being relevant for cater for the very different starting position of GDP. This consists of an assessment of key Member States, and balances the need for indicators (mostly structural indicators of consistency across Member States with the need Eurostat and the Employment Committee) to take account of wide differences in countryrelevant for each of the 20 policy areas. specific institutional settings and circumstances.

In order to allow a comparison across countries However, results should be interpreted cautiously and policy areas, a standardised continuous due to some limitations. First, the usual caveats scoring system has been applied to assess associated with growth accounting apply, e.g. no performance of GDP components as well as information is provided on causality. Secondly, policy areas, both for levels and changes. The for an important number of indicators, 2006 is the scores are calculated as: reference year to determine the level of

Indicator − Indicator performance and therefore the data does not

Score = OMS * 10

St . deviation reflect reforms taken by Member States since OMS

then. Moreover, due to inevitable time lags, many of the indicators may not reflect the impact of recent reforms. Finally, the LIME Assessment

( 1 ) This work was undertaken in the context of the Framework does not cover a number of mandate of the Lisbon Methodology (LIME) dimensions and objectives falling under the

Working Group and details on the developed

methodology can be found in European Commission Lisbon strategy and the Integrated Guidelines,

(2008j). such as quality at work, work organisation, social

( 2 ) The results of the GDP decomposition are not cohesion and social adequacy, quality of and

reported in this chapter. An interested reader should access to education. refer to Mourre (2009).

In the microeconomic area, the extent of greater underperformance in financial markets underperformance appears higher for new and business environment.

Member States in several areas: competition policy framework, ICT and, in particular, R&D and innovation. The extent of the challenges seems to be even more pronounced in Bulgaria and Romania. These countries, moreover, show

European Commission

Five years of an enlarged EU

Graph VII.2.3: Policies in the employment and micro pillar areas which make it possible to identify groups

that share similar patterns of performance( 77 ).

Employment pillar (The smaller the ALMPs circle, the bigger the

10 challenge)

Labour market mismatch Making work pay While it does not seem to be possible to draw a

and labour mobility clear dividing line between the new and the old Immigration and -10 Member States, at the most aggregated level

integration Labour

policies taxation there seem to be two relatively clearly defined

-30 groups of countries (Graph VII.2.4). One group comprises Austria, Belgium, Cyprus, Germany,

Wage bargaining Job

and wage-setting protection Denmark, Estonia, Finland, France, Ireland, Lithuania, Luxembourg, Malta, the Netherlands,

Labour supply measures Increasing working Sweden, Slovenia and the UK, and the other

for older-workers time

EU-15 group consists of Bulgaria, Czech Republic,

Labour supply measures EU-10

for women BG+RO Greece, Spain, Hungary, Italy, Latvia, Poland,

Micro pillar

Competition policy Portugal, Romania, Slovakia. It is quite

framework interesting to observe that the second group

10

Education and lifelong Sector regulation actually contains a majority of the new Member learning (telecom, energy) States plus the Mediterranean EU countries.

-10

ICT Business Graph VII.2.4: Clusters of countries: performance in policy areas

environment -30

LT EE

R&D and Business AT Innovation Dynamics UK

SE

Market integration and Financial markets DK trade FI

EU-15 EU-10 BG+RO NL

SI

Note: The values represent (unweighted) average aggregate scores for FR each policy area computed for each group of countries. As explained BE in Box VII.2.2, the scores range between -30 (the worst performance) DE and +30 (the best performance). The value of 0 indicates performance LU equal to the EU-15 benchmark (computed as a weighted average). IE Source: Commission services MT

C Y

In addition, in the policy areas where both RO HU

groups as a whole have a similar level of LV

underperformance (e.g. making work pay), there C Z IT

appears to be a greater diversity among the new BG

Member States than in the old Member States, SK PL

suggesting that a greater degree of ES

underperformance in some countries has been EL PT

offset by a much better performance in others. 0 80 160 240 320

Source: Commission services

2.3.3. Patterns of performance

The analysis has so far pointed to an important These countries are characterised by a relatively degree of heterogeneity across Member States in larger number of underperforming policy areas

terms of the nature as well as extent of structural challenges they are facing. How does this square

with the fact that the new Member States, due to ( 77 ) The results are based on hierarchical cluster analysis

their transition experience, are often perceived as which allows grouping together objects that are similar

a homogenous group? To answer this question it to one another. The method exploits an algorithm that

is possible to apply statistical clustering groups the objects on the basis of a distance measure. In this case, the squared Euclidean distance measure was

techniques on the aggregate scores for policy used and the clusters were determined with the Ward

clustering algorithm.

Chapter VII

Enlargement and the EU policy framework

which are spread across all three domains Graph VII.2.5: Progress in Lisbon strategy: average scores for a

(macro, micro and employment). Within this set of headline indicators group, further specific subgroups can be 12 change O MS Ave rage BG

identified (e.g. the Mediterranean countries 10 except Italy). It is also worth noting that Cyprus, EE

Malta and Slovenia – the first new Member 8 SK C Y

States to join the euro area – were clustered in 6 MT

the first group, together with two Baltic countries RO 4 DE FI

(Estonia and Lithuania). PL C Z BE IE 2

GR PT

LV

SI LU LT

AT NL

SE

Results thus show that a majority of the new 0 HU ES

Member States actually share similar patterns of O MS Ave rage -2 IT

performance across policy areas. Nonetheless, UK DK -4 FR

this pattern is not confined to them and some of

the old Member States seem to have similar -6

l e ve l

-15 -10 -5 0 5 10 15

characteristics. This should, of course, be seen

against the backdrop of the considerable Note: The average score is based on a list of 36 indicators covering the main areas of the Lisbon strategy. These indicators largely come

diversity between the old Member States from the set of indicators used in the assessment framework presented

themselves. in the section 2.3. For the tractability of the exercise, key indicators were selected which have sufficient time coverage. In addition,

several indicators covering additional policy areas such as energy and climate change were added. The score for each indicator is computed on the basis of the formula presented in Box VII.2.2. The level

2.4. PROGRESS SINCE THE RELAUNCH OF THE calculation is based on 2006/7 data and the change on the period

STRATEGY 2005-2007. Source: Commission services

In many of the EU countries, there has been

progress on many issues that form part of the Lastly, Hungary has not experienced any

Lisbon agenda since 2005. In particular, most of improvement compared to the EU-15 average, the new Member States have recorded significant and convergence has stalled. The situation in the progress, as a result of which they have quickly old Member States is more diverse. On the one converged with the performance of the old hand, a group of countries (Austria, Member States. Graph VII.2.5 measures the Luxembourg, Belgium, Finland, Germany, progress in terms of average scores for the level Ireland, the Netherlands and Sweden) have and change of 36 selected indicators that cover achieved above-average progress and have the main areas and policies pursued in the Lisbon strengthened their good starting positions. On the strategy( 78 ). It shows that most of the new other hand, other countries are defending Member States are rapidly catching up with the positions which may be threatened due to their old Member States, as they have recorded aboveworse-than-average performance (Denmark, average improvements, thus reducing the France and the UK) or are further losing ground existing gap in terms of level performance. The as they combine relatively low level performance pace of progress has been particularly fast in with dismal average growth in the relevant Bulgaria, Estonia, Cyprus, Slovakia, Malta and indicators (Italy and Spain). Greece and Portugal Romania. There were relatively modest belong to the group that is catching up, although improvements in Poland, Czech Republic, the rate of progress is not very fast.

Lithuania and Slovenia. In Poland, especially, progress appears very slow given the large gap

between its performance and the EU-15 average. 2.5. CONCLUSIONS

The new Member States have made significant progress in terms of implementing structural reforms. In the process of accession to the EU,

( 78 ) The scores for individual indicators are based on the they transformed their economies from the

formula presented in the box VII.2.2. The list of centrally planned to the fully fledged marketindicators can be found in a companion document to the based model. In some cases, the new Member

"European Economic Recovery Plan", COM(2009) 34 i/2.

European Commission

Five years of an enlarged EU

States managed to exploit the considerable structural reforms can help boost confidence reform momentum and push the reforms further among households and firms. Structural reforms than the old Member States, which had need to form an integral part of the response to experienced hold-ups in reform due to social and the slowdown as outlined in the European

political resistance and a status quo bias. On the Economic Recovery Plan. other hand, the process of institution building is inevitably a gradual one and many shortcomings remain. Moreover, the new Member States are still much further from the global technological frontier than the old Member States.

The Lisbon strategy for growth and jobs was designed to promote and coordinate structural reform in the Member States by means of common guidelines, policy recommendations, peer pressure and exchange of experiences. The adoption of the new procedural arrangements by the new Member States has gone smoothly. As a result, they experienced a fundamental change in the governance of the domestic reform processes and the associated weakening of the external pressure to implement reforms. They appear to be coping fairly well. Reform efforts seem to have increased in some countries and some policy areas, though this is not a systematic picture. From the institution building point of view, the new Member States have benefited from participation in the Lisbon strategy through a strengthening of the coordinated approach to policy making at domestic level.

As for the future reform priorities, the microeconomic area seems to be the one where there is most room for improvement in the context of structural reforms in all EU Member States, and underperformance in new Member States seems to be much more acute than in the old ones. While in some areas related to the labour market new Member States perform rather well, there are also serious weaknesses. What is needed, therefore, is a comprehensive approach to structural reform.

Structural reforms are all the more necessary in the current conditions of namely financial crisis, wavering growth and low consumer confidence. While the full benefits of these reforms usually come only after some time, there are reforms that can have a considerable positive impact even quite soon after being implemented (e.g. cuts in red tape, increases in competition, or policies to make work pay). Moreover, by creating the conditions for higher growth in the longer run,

• 3. 

  FISCAL SURVEILLANCE

This section starts with an overview of fiscal deficits. As for the central European countries, performance since EU accession. In addition to Hungary's headline deficit peaked at an presenting the key developments in budget unprecedented 9.2% of GDP in 2006, although balances and debt, this first subsection will this was followed by a very considerable briefly cover the history of the excessive deficit improvement. In Poland, the deficit decreased procedures and adjustment towards the mediumsteadily from an initially high level, and by 2007 term budgetary objectives. had fallen below 3% of GDP; in the Czech

Republic and Slovakia it exceeded the 3% Next, the contribution of fiscal policy to macro - threshold only intermittently. Slovenia ran small financial stability will be analysed. At the time of deficits throughout the period. In the case of the joining the EU, many of the new Member States island states, deficits in excess of 3% of GDP were experiencing both rapid catch-up growth were steadily reduced, and in Cyprus (following and a concomitant growth of credit, and external data corrections) they were replaced in 2007 by a imbalances were increasing. Since then, large surplus. As for the South-East European macroeconomic imbalances have continued to countries, the Romanian headline deficit grow apace. So the core issue is whether deficits continued to grow, coming close to the 3% and debt have been contained to the extent threshold in 2007, while Bulgaria reported necessary to cope with the current financial crisis surpluses throughout. However, as a result of the and to insure against further risks to macrocurrent financial crisis, budget balances are financial stability, or whether even more prudent expected to worsen again soon in the new fiscal policies are required. Member States, albeit at a slower pace than in

the old Member States. Then, in a longer-term perspective, the scope for improving the quality of public finances will be As with the headline budget balances, in most analysed. A particular focus is on growthnew Member States structural balances were enhancing public investment, which may matter improving or approximately constant between for stable convergence and hence could in itself accession and 2007. A small but steady increase justify fiscal deficits. However, standing against in the structural deficit took place in Latvia this is not only the need to safeguard macroduring that period, while the Czech Republic, financial stability but also considerations Slovakia, Hungary, and Slovenia intermittently stemming from other aspects of quality. A reported deteriorations. closely related issue is the policy response to the challenge of long-term sustainability. The improvements in the budget and structural

balances in Cyprus, Slovakia, and also in Poland were mainly revenue-driven, while those in the

3.1. RECENT FISCAL PERFORMANCE Czech Republic, Slovenia, Malta, and Bulgaria were mainly expenditure-driven. Mainly

Like the old Member States, the years after expenditure-driven consolidation (omitting accession - at least up to 2007 - were interest expenditure) bodes well for a lasting characterised by improved (nominal) budget and correction of the government deficit (Alesina and structural balances, and by lower debt ratios. Perotti, 1997). Cyprus is a special case (with Moreover, as in the old Member States, various much of the fiscal developments being due to excessive deficits were corrected, and progress data revisions), while Slovakia has one of the towards the medium-term budgetary objectives lowest tax burdens, and Poland has also recently (MTOs) was achieved. engaged in cutting expenditure. The recent

reduction of the very large Hungarian deficits Nevertheless, among the new Member States, the has relied on a combination of both revenue and development of budget balances has been very expenditure measures. varied (Table VII.3.1). Starting with the Baltic

States, Estonia posted a budgetary surplus throughout the period since 2004, while

Lithuania and Latvia generally reported small

pean Commission

Five years of an enlarged EU

Table VII.3.1: Budget balances in the new Member States

% of GDP 1999 2003 2004 2005 2006 2007 2008 BG 0.4 -0.3 1.6 1.9 3.0 0.1 3.2 CZ -3.7 -6.6 -3.0 -3.6 -2.7 -1.0 -1.2 EE -3.5 1.7 1.7 1.5 2.9 2.7 -2.0 CY -4.3 -6.5 -4.1 -2.4 -1.2 3.4 1.0 LV -3.9 -1.6 -1.0 -0.4 -0.2 0.1 -3.5 LT -2.8 -1.3 -1.5 -0.5 -0.4 -1.2 -2.9 HU -5.4 -7.2 -6.4 -7.8 -9.3 -5.0 -3.3 MT -7.7 -9.8 -4.7 -2.8 -2.3 -1.8 -3.5 PL -2.3 -6.3 -5.7 -4.3 -3.8 -2.0 -2.5 RO -4.5 -1.5 -1.2 -1.2 -2.2 -2.5 -5.2 SI -2.0 -2.7 -2.2 -1.4 -1.2 0.5 -0.9 SK -7.4 -2.7 -2.3 -2.8 -3.5 -1.9 -2.2 EE, LT, LV -3.4 -0.4 -0.3 0.2 0.8 0.5 -2.8 CZ, HU, PL, SI, SK -4.2 -5.1 -3.9 -4.0 -4.1 -1.9 -2.0 CY, MT -6.0 -8.2 -4.4 -2.6 -1.7 0.8 -1.3 BG, RO -2.1 -0.9 0.2 0.3 0.4 -1.2 -1.0 NMS -3.4 -5.1 -3.9 -3.5 -3.4 -1.8 -2.5 OMS -0.8 -3.0 -2.8 -2.4 -1.3 -0.8 -2.0

Source: Commission services

Debt ratios in the Baltic States and in Estonia in country-specific factors into account. Except for particular have remained at very low levels Hungary, the Council considered in January during the whole period since 2004. Conversely, 2005 that all countries had taken effective action. in Hungary, the debt ratio has remained above For Hungary the Council had recommended a 60% of GDP throughout. In the other Central correction by 2008 and was only satisfied with European countries, the relatively small debt the measures adopted in July 2007. In June and ratios were declining, at a varying pace. Cyprus July 2008, the excessive deficit procedures for and Malta steadily reduce their debt ratios, from Poland, the Czech Republic, and Slovakia were more than 60% of GDP initially. Very low debt abrogated. The Excessive Deficit Procedure for ratios were posted during the entire period by Cyprus had already been abrogated in June 2006 both Romania and Bulgaria. On the other hand, and for Malta in June 2007. In June 2008, the the debt ratios during the years 1999-2003 were Commission also issued a policy advice to also low in general, but moved in both directions. Romania, urging it to step up the pace of fiscal consolidation. In the light of the current financial So, the years 2004-2007 show an improvement crisis, it appears likely that more of the new in most fiscal variables as compared to the Member States will soon be subject to the

previous five years (1999-2003). Indeed, some excessive deficit procedure once again. new Member States (such as the Baltic States, Slovakia and Romania) had already reduced their However, in order to evaluate fiscal budget deficits during that earlier period, while performance, it is not only the avoidance of the others experienced intermittent excessive deficits that matters, but also progress deteriorations. towards attaining the medium-term budgetary objectives. The achievement of sound fiscal In July 2004, on the basis of recommendations positions in the medium term protects Member by the Commission, the Council decided that an States from running an excessive deficit under excessive deficit existed in six new Member adverse economic circumstances. Moreover, it is States: Hungary, Poland, the Czech Republic, an absolute necessity in the light of the implicit Slovakia, Cyprus, and Malta. It issued a liabilities building up from ageing. recommendation in order to correct it (for overviews of excessive deficit procedures and recent abrogations see European Commission, 2008g, and 2007). A number of deadlines were set, ranging from 2005 to 2008, which took

Chapter VII

Enlargement and the EU policy framework

Graph VII.3.1: Structural budget balances in the new Member States

4 EE, LT, LV CZ, HU, PL, S I, SK CY, MT BG, RO NMS O MS

3

2

P 1 D

f G 0

 o

% -1

-2

-3

-4

-5 EE LT LV CZ HU PL S I S K C Y MT BG RO

MTO 2004 2005 2006 2007 2008

Source: Commission services

The medium-term budgetary objectives in the mid-1990s, accompanied by economic volatility, new Member States are often rather less including that of inflation in particular. Healthy ambitious than those in the old ones, which may growth in credit is a key support for the catchingbe justified by the generally lower debt ratios and up process, but it is important to guard against higher potential growth rates. Moreover, only excessively strong cycles in credit, asset prices, some of the new Member States have been the external current account and the real members of the euro area or the ERM II, and exchange rate, which could jeopardise stability. hence subject to the SGP requirement to achieve Banking supervision can play a valuable role a reduction of the structural fiscal deficit of 0.5% here, and so can monetary policy. of GDP annually as a benchmark.

Prudent fiscal policy can also make an important Adjustment towards the medium-term budgetary contribution to stability by moderating any credit objectives, or where applicable the preservation booms ( European Commission, 2005c) . In of structural fiscal positions at these, has been particular, it balances strong private investment uneven across the new Member States (Graph which causes a widening of the external current VII.3.1). Estonia has remained at or surpassed account deficit. On the other hand, additional its medium-term budgetary objective throughout fiscal headroom can prove useful under the period since 2004, while Latvia and conditions such as those of the current financial Lithuania fell short of it more recently. Sizeable crisis, which threaten confidence. So, during an improvements (often after earlier deteriorations) extended boom, countries should run smaller were achieved in Hungary, Poland, the Czech deficits or larger surpluses than required by the Republic, and Slovakia. Slovenia and Cyprus provisions of the SGP in order to ensure debt attained their medium-term budgetary objective sustainability and to allow the free play of in 2007, while Malta continued its progress. automatic stabilisers in future downturns. Romania moved further away from its medium Transparent and credible medium-term term budgetary objective from 2007 onwards, budgetary frameworks can be instrumental to this while Bulgaria maintained increasingly large end. In the same context it is important not to structural fiscal surpluses throughout. overestimate potential growth, and to realise that

strong tax gains might in part prove temporary, especially when they occur in periods of rising

3.2. SAFEGUARDING MACRO-FINANCIAL asset prices ( Jaeger and Schuknecht, 2004) . A

STABILITY stronger view would be that prudent fiscal policy may trigger higher growth even in the short run,

The transition from a centrally planned to a especially through credibility effects (Rzonca market economy in nearly all the new Member and Cizkowicz, 2005).

States has triggered strong GDP growth since the

pean Commission

Five years of an enlarged EU

Table VII.3.2: Volatility in fiscal variables, 2004-2008

Revenues Primary Implicit interest expenditures Primary deficit rate on debt Debt

standard deviation 99-03 04-08 99-03 04-08 99-03 04-08 99-03 04-08 99-03 04-08 BG 0.5 0.8 0.6 1.1 1.4 0.5 0.9 0.5 14.0 9.5 CZ 1.0 0.6 2.3 1.5 1.4 1.0 1.0 0.2 6.0 1.4 EE 0.7 1.0 2.2 2.6 1.9 1.8 0.9 0.3 0.5 0.6 CY 2.2 3.4 3.3 0.8 1.8 2.8 0.4 0.1 4.4 9.0 LV 2.2 1.5 3.0 1.7 0.9 0.9 1.4 0.8 1.0 2.0 LT 2.2 0.9 2.7 1.5 0.8 1.0 1.2 0.1 1.0 0.9 HU 0.7 1.5 2.6 1.3 3.2 2.3 2.1 0.7 2.9 3.0 MT 1.4 0.6 2.6 1.1 1.8 1.1 0.7 0.1 5.3 4.6 PL 0.9 1.4 1.4 0.7 1.6 1.4 0.6 0.2 4.2 1.6 RO 6.3 1.2 3.3 2.3 3.7 1.1 13.5 1.0 1.9 2.7 SI 0.4 1.0 0.4 1.6 0.5 0.7 1.5 0.5 1.7 2.6 SK 1.5 1.4 3.5 1.3 2.9 0.7 1.6 0.4 3.5 5.2 EE, LT, LV 1.7 1.1 2.7 1.9 1.2 1.2 1.1 0.4 0.8 1.2 CZ, HU, PL, SI, SK 0.9 1.2 2.0 1.3 1.9 1.2 1.4 0.4 3.7 2.8 CY, MT 1.8 2.0 3.0 1.0 1.8 1.9 0.5 0.1 4.8 6.8 BG, RO 3.4 1.0 2.0 1.7 2.5 0.8 7.2 0.8 8.0 6.1 NMS 1.7 1.3 2.3 1.5 1.8 1.3 2.1 0.4 3.9 3.6 OMS 1.0 0.8 1.2 1.1 1.8 1.2 0.6 0.3 3.3 3.4

Source: Commission services

The exchange rate regime also matters for fiscal At the country level, the Baltic States and also policy. Where monetary policy autonomy is Romania and Bulgaria appear particularly maintained with floating exchange rates, it is volatile with respect to primary expenditure, important to slow the build-up of borrowing while for Cyprus and Malta the volatility is with denominated in foreign currency-, which could respect to revenues and debt. Latvia, Hungary expose economies to balance-sheet risks. Where and Romania remain relatively vulnerable to the new Member States relinquish domestic interest rate developments, given the volatility

control of interest rates for fixed exchange rates, observed for that variable in these countries. there could be a greater risk of any instability spreading. Thus here the case for prudent fiscal The effects of the current financial crisis on policy is even stronger. public finances are still difficult to gauge. Deteriorations in headline balances appear likely The economies of the new Member States as in most, if not all, new Member States. Overall, well as their public finances appear to be more this further strengthens the case for sound public volatile than those of the old Member States. finances in the medium term. However, at the Since accession, however, volatility has been current juncture some limited discretionary declining. The variability of the interest rate on loosening may also be appropriate in some public debt, in particular, has diminished countries. Indeed the budgetary deteriorations are significantly thanks to the anchor of stability that also partly due to participation in the European the EU policy framework provides (Table Economic Recovery Plan, which focused on VII.3.2 ). 2009 but also covered 2010. This participation is proportionately weaker in the new Member A less stable economy makes economic and States, given the fact that in some of them fiscal forecasting more difficult (Keereman, growth has been resilient, while others have no 2005) and strengthens the case for a prudent fiscal space (indeed, Hungary and Latvia benefit budgetary policy. In particular, general from financial assistance). So the only new government revenue and primary expenditure (as Member States which have launched fiscal % of GDP) display a higher degree of variability stimulus packages so far are Poland, the Czech in the new Member States compared to the old Republic, Slovenia and Malta. Conversely, in Member States; this can be explained in part by Latvia, Lithuania, Hungary, Slovakia, Romania, the relatively wider fluctuations in inflation. and Bulgaria, such packages have been non Also, debt seems to be rather more volatile. existent or their size has been negligible.

Chapter VII

Enlargement and the EU policy framework

3.3. PUBLIC INVESTMENT AND THE QUALITY to determine the extent to which a loosening of

OF PUBLIC FINANCES the fiscal stance can be taken into consideration in order to cater for this extra public investment.

3.3.1. Public investment and the fiscal

stance Over the long term, these two roles of fiscal

policy are complementary, because strong Apart from helping to contain any risks to the growth enhances the economy’s debt-carrying stability of the economy, fiscal policy can also capacity. In the short run, however, there can be contribute to the catching-up process of the new tensions between safeguarding stability and Member States through growth-enhancing public financing priority programmes. The possibility of investment. Here the focus is on infrastructure, such a trade-off in the new Member States has R&D and education. Between 2004 and 2008 a been a matter of recent academic and policy strongly positive relation between public debates on the design of fiscal policy, with investment and real GDP growth can be varying conclusions being drawn as to the pace observed in the new Member States (Graph of consolidation. While one view taken is that VII.3.2). there is potential for supporting growth by

accommodating wider fiscal deficits than those It could be argued that joining the EU has prescribed by the SGP in the new Member reduced public investment because of the more States, it may also be held that the risks to stringent fiscal rules. However, the evidence macro-financial stability dictate a very cautious suggests that this is not the case (Jevcak and fiscal stance. A potential trade-off has also to Keereman, 2008). In most new Member States, take into account the stabilisation role that fiscal including the larger ones which were in EDP, policy has in times of economic hardship as public investment as a share of GDP continued to experienced since 2008. rise during the period 2004-08 to levels close to

4% on average across countries and over time. 3.3.2. Improving the quality of public

These developments differ from those in the old finances

Member States, where public investment remained almost constant during both periods Looking beyond public investment proper, there (with an unweighted average of around 2.5% of are other dimensions of the quality of public GDP). finances that matter for stable convergence

(European Commission, 2008d, 2008g). These Graph VII.3.2: Public investment, 2004-08 are (i) debt sustainability, (ii) expenditure

10 Re al GDP growth composition and (iii) fiscal governance, and

y = 0.76x - 2.36

9 R 2 = 0.59 LV these will be discussed in turn.

8 EE Debt sustainability

7 NMS LT

O MS NMS NMS 6 BG RO High public debt (and large deficits) impinges on

SI PL C Z 5 savings and investment decisions and has a

C Y LU IE 4 FI EL negative effect on growth. First, it may raise the

UK SE O MS ES 3 real interest rate and thereby crowd out private

AT HU DK MT

2 BE NL investment. Second, economic agents who regard FR y = 0.27x + 1.16

DE O MS IT R 2 = 0.46 the current fiscal policy as unsustainable might

1 PT

 Publi c i nve stme nt as % of total pri mary e xpe ndi ture increase their savings (or reduce their

0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 investments) to protect against future tax

increases( 79 ). And third, ill-designed Source: Commission services consolidation efforts to reduce debt, which focus

on raising taxes or curbing public investment,

There is a broad consensus that fiscal policy can may have a negative impact on long-run growth

make a contribution to potential growth through supply-side effects (Gemell and Kneller, 2001

) This could in part also lead to massive capital outflows.

pean Commission

Five years of an enlarged EU

Table VII.3.3: Growth and the quality of public finances: selected indicators for the EU Member States, 2004-08

% of GDP except where indicated EE, LT, LV CZ, HU, PL,

SI, SK CY, MT BG, RO NMS OMS

Average GDP per capita growth rate 6.0 5.2 2.2 7.2 5.7 1.6 1. The size of the government Government expenditure 35.6 43.6 44.0 36.9 40.5 46.4 2. Fiscal balance and sustainability Size of budget balance 0.4 -1.0 1.5 1.4 0.1 1.8 Public debt 11.5 39.4 64.5 19.5 33.3 55.3 3.Composition of expenditure Consumption 17.8 19.6 19.0 16.7 18.6 20.7 Investment 4.4 3.6 3.7 4.5 4.0 2.6 4. Structure of revenues Indirect taxes 12.2 13.5 16.5 15.4 14.0 13.8 Direct taxes 8.5 8.3 11.7 6.3 8.6 14.4 5. Fiscal governance Overall fiscal rules index 0.60 0.42 -1.0 0.5 0.23 0.81 Expenditure fiscal rules index -0.42 0.14 -0.6 0.5 -0.06 0.69

Note: The fiscal rule and expenditure indices are computed as a combination of different indices of coverage and strength. Coverage refers to what part of general government finances is covered by numerical rules, while strength is measured by taking into account five criteria such as the statutory base of the rule or its enforcement mechanisms (European Commission, 2006c). Source: Commission services

 (Tanzi and Chalk, 2002). These effects seem to Hungary, Slovenia and Cyprus. Slovakia and be more prominent in the new Member States Malta are at medium risk, while Estonia, than in the old Member States (Graph VII.3.3), Lithuania, Latvia and Malta are at low risk (no warranting stronger efforts to contain public overall risk assessments have been made yet for

debt, in spite of the lower debt levels overall in Romania and Bulgaria). the first group. Furthermore, the new Member States with the lowest debt levels managed to The new Member States appear to have achieve the best growth rates (Table VII.3.3 ). acknowledged the risks and have adopted substantive pension and other structural reforms Graph VII.3.3: Public debt, 2004-08 (Box VII.3.1). In order to facilitate 9 Re al GDP growth implementation, the SGP allows the costs of

LV y = -0.07x + 8.09 structural reforms and of systemic pension 8

SK R 2 = 0.76

LT reforms in particular to be taken into account

7 RO NMS EE O MS

when determining the appropriate path of 6 BG NMS NMS structural fiscal adjustment. However, these

SI

5 LU C Z PL provisions have been invoked only once - by

Lithuania and Latvia in 2005, while with regard 4 IE

C Y EL FI ES

SE to the corrective arm of the Pact they were

3 O MS

HU

MT BE considered in Poland in 2007, but ultimately

UK NL

2 DK AT were not used given the favourable development FR

y = -0.02x + 3.96 DE of the deficit. 1 R 2 = 0.32 PT O MS IT

Publi c de bt as % of GDP

0 Expenditure composition

0 10 20 30 40 50 60 70 80 90 100

Source: Commission services Well-designed expenditure policies can help

create the conditions for strong growth in the

Moreover, some new Member States run the risk private sector, also via fiscal support for of their public finances becoming unsustainable economic restructuring, including the cushioning in the light of the projected costs of pension and of distributional hardships. However, the long-term care systems (European Commission, necessary additional fiscal space may also be 2008g). These developments could eventually created by improving the efficiency and also have implications for their long-term growth effectiveness of expenditure and revenue, rather prospects. The Member States that are classified than simply its composition. For instance, new

as high-risk countries are: the Czech Republic,

Chapter VII

Enlargement and the EU policy framework

expenditure can often be offset by phasing out subsidies and streamlining administration.

The composition of expenditure (Table VII.3.3 ) reveals slightly higher shares of investment and slightly lower shares of consumption in the

Baltic States and in the South-East European countries than in the other Member States. This is likely to have been an influential factor in terms of growth.

Fiscal governance

In the trade-off between budgetary consolidation and spending for catching-up, a strengthening of fiscal rules and institutions provides scope to improve possible difficult choices (for a survey of existing fiscal rules and institutions in most of the new Member States, see Ylaeoutinen, 2004;

Gleich, 2003, focuses on the effects of budgetary procedures on fiscal discipline). By improving their budgetary performance, Member States with more developed fiscal rules – such as the

Baltic States ( 80 ) – may generate higher growth

rates than countries with less developed fiscal rules, such as the central European countries

(Table VII.3.3 ).

( 80 ) In the new Member States the relationship appears

tentatively stronger for overall fiscal rules and not necessarily for expenditure rules).

pean Commission

Five years of an enlarged EU

Box VII.3.1: Reforms of pension systems in the new Member States

As in the old Member States, the recently others (including Latvia and Poland) could acceded countries have been facing the encounter difficulties securing adequate income

population ageing problem, which has adverse for their pensioners. Therefore, it seems that the implications for the sustainability of public introduction of mandatory funded pension

finances and for economic growth. However, the provisions does not automatically help to reach pension systems in the new Member States the goal of sustainable pensions. Moreover, if

followed in some respects different development mandatory funded schemes are to deliver an paths from those in the old Member States. First, adequate income for pensioners, they require a

their point of departure was different, as after the reasonable strategy to shoulder the net transition fall of communism their pension schemes costs of their introduction, a transparent

continued to be structured along socialist environment where comparability of charge principles. Second, prior to accession to the EU levels is possible and a careful design for the paythese countries launched significant reforms of out phase to deal with longevity and inflation which the majority consisted of partial risks (Social Protection Committee, 2006). privatisation of pension provision and the creation of mandatory funded private pension Although there is a vast diversity of pension schemes. Furthermore, the new Member States systems within the EU as the Member States are have only recently acknowledged the challenge ultimately responsible for framing them, all of population ageing, while over the past decade agreed on the following three goals in the long reforms of pension systems within the EU-15 run (European Commission, 2005b): countries were undertaken in response to current and projected consequences of this problem. - adequate retirement incomes and access to pensions that allow to maintain living standards The majority of reforms undertaken in the new after retirement; Member States prior to accession consisted in partial privatization of pension provision and the - financial sustainability of public and private creation of mandatory funded private pension pension schemes through balancing contributions schemes along the Pay-As-You-Go schemes. and benefits in a socially fair manner. This can be "While the possibility of a demographic fiscal achieved, among others, through supporting crisis may help to explain the propensity to adopt longer working lives and active ageing, as well as pension privatization in the new Member States, promoting affordability and security of funded it does not provide a sufficient explanation for and private schemes; this trend" (Orenstein 2008, p.904) as, in general, the new Member States have younger populations - transparency of pension systems. Pension compared to the EU-15 countries. A private systems should respond to needs and aspirations solution to the pension problem reflects also the of both women and men, structural changes and general liberalisation process and willingness to demographic ageing. embrace the markets in the new Member States. This privatisation of pension provision is a wide In sum, in all the EU Member States the statutory movement, taking the form of increasingly Pay-As-You-Go schemes generate a large share shifting risks of employment, longevity and of pensioners' income but the role and funding from the pension provider to an development of private funded pension provision individual. is very diverse across Member States. It seems, however, that the mandatory funded private According to the projections, in the absence of pension schemes, complementing the unfunded additional reforms of pension schemes and labour Pay-As-You-Go ones, are now most widespread market arrangements, some of the EU-8 countries in Central and Eastern Europe. (e.g. Slovenia, Hungary, the Czech Republic and Cyprus, classified at high risk in the Council Opinions on the Stability and Convergence Programmes) may encounter difficulties securing the sustainability of their pension systems, while

(Continued on the next page) Chapter VII

Enlargement and the EU policy framework

Box (continued)

Table 1: Main measures in the Pre-Accession Economic Programs concerning pension reform, and recent or planned reforms in new Member States

Funded pillar - Reforms planned due to accession Recently introduced or planned reforms development First pillar: parametric reforms within fiscal The reform of 2008 was focused on improving consolidation, notional defined contribution sustainability (gradual increase in the retirement

Czech Republic no reform foreseen for 2010. No plans for the age, increased length of required minimum

compulsory funded pillar contribution period, new definition of disability

pensions)

Recent changes to the indexation of pensions to

Estonia yes address the challenge of inadequate pensions in

the future

More generous indexation rule in the notional Supplements to old-age pensions were

defined contribution pillar introduced in 2006 to alleviate poverty among

Latvia yes pensioners, but relative spending on pensions

still one of the lowest in the EU

Introduction of a voluntarily pillar as of 2004 Establishment of mandatory funded scheme with

Lithuania no voluntary opt-in in 2004. Provision of assistance

pension was extended in 2006.

Gradual introduction of the thirteenth-month The government intends to limit the thirteenth Hungary yes pension. Increase contribution rate to mandatory month pensions due to difficult situation of

funded pillar public finances Reforms in progress: introduction of annuities in

Poland yes the mandatory funded scheme and limiting the number of professions entitled to early pensions

Slovenia no Parametric reforms in the first pillar

Introduction of a compulsory funded pillar In 2008 the mandatory character of the funded Slovakia yes planned for 2005 pillar was changed to optional for the new

entrants into the labour market

Source: Helmut Wagner (2005), and European Commission (2009, forthcoming)

• 4. 

  ECONOMIC AND MONETARY UNION

This section reports on the process of euro area to sixteen Member States as Slovenia, Cyprus, enlargement to the new Member States since Malta and Slovakia have joined the group. More 2004. The EC Treaty stipulates that the policies countries are set to follow over the next years, of the Member States should be directed towards although major differences remain between the the introduction of a single currency. EU various candidates in their progress with nominal membership therefore involves the requirement convergence. to adopt the euro when a Member State fulfils

the necessary conditions ( 81 ). Seven new Member States joined the exchange

rate mechanism (ERM II) in the course of 2004 The section first looks at developments in the and 2005. The three Baltic countries (Estonia, monetary and exchange rate regimes of the new Latvia and Lithuania) are currently participating

Member States over the past five years ( 82 ), in the mechanism, all of them with unilateral going on to examine their progress with nominal exchange rate commitments ( 83 ). Estonia and

convergence since 2004. Subsequently, some Lithuania, in addition to their obligations arising stylised facts of the convergence process are from ERM II membership, maintained their explored. Despite being a heterogeneous group, currency board arrangements, while Latvia the new Member States do share a number of joined the mechanism with a unilateral +/- 1% characteristics (notably related to their economic fluctuation band against the euro. Bulgaria, the catching-up process) which tend to accentuate Czech Republic, Hungary, Poland and Romania certain convergence-related risk factors such as have not yet entered the mechanism. rapid credit expansion and high external deficits

(see also Chapter IV.2). Finally, the section Adopting a stylised approach, the "pre-in" new draws some policy conclusions for the new Member States can be divided into two broad Member States en route towards the adoption of groups pursuing fixed and more flexible the euro. It underscores the central role of exchange rate regimes respectively (Table stability-oriented macroeconomic policies, and VII.4.1.). One group operates hard pegs vis-à-vis the importance of enhancing domestic the euro, either through currency board adjustment mechanisms and of containing arrangements (Estonia, Lithuania and Bulgaria) potential vulnerabilities. This is seen as a or a conventional peg (Latvia). These countries prerequisite for a smooth convergence process as have already been pursuing exchange rate well as for the functioning of the economies stability for a prolonged period, which has served within the euro area. to anchor expectations and import credibility.

Given their generally small size and high degree of openness, they consider the scope for

4.1. MONETARY AND EXCHANGE RATE autonomous monetary policy to be limited, and ARRANGEMENTS IN THE "PRE-INS" outweighed by risks of excessive exchange rate volatility amid shallow financial markets. Before

Since 2004, the euro area has undergone three joining the euro area, Cyprus and Malta had rounds of enlargement. It has grown from twelve already had a long-standing tradition of currency

pegs, although the Maltese lira had to be repegged from a basket of currencies to the euro

( 81 ) The Treaty does not grant to the new Member States the upon ERM II entry.

possibility to opt-out from the provisions on economic

and monetary union as it does to Denmark and the The second group (the Czech Republic, Poland,

United Kingdom. On the basis of their special status,

legally enshrined in two protocols annexed to the Treaty, Romania and Hungary) operates more flexible

Denmark and the United Kingdom can decide whether exchange rate arrangements. All of them

they intend to steer their policies towards the monetary currently have domestic monetary anchors

union and, once they fulfil the necessary conditions, to through inflation targeting, supplemented with

adopt the euro.

( 2 ) Given the very short time that the four new Member

States (Slovenia, Cyprus, Malta and Slovakia) have spent in the euro area, this section will mostly focus on

convergence-related issues prior to euro area ( 83 ) Denmark has participated in ERM II since its inception

enlargement. in 1999.

Chapter VII

Enlargement and the EU policy framework

Table VII.4.1: Monetary policy regimes in the new Member States

Monetary Policy Regime ERM II participation

Bulgaria currency board -

Czech Republic Inflation targeting; managed float -

Estonia Currency board; ERM II since 28 Jun 2004 Cyprus Euro area Member State (since 1 Jan 2008) from 02 May 2005 to 31 Dec 2007 (standard +/-15% band)

Hungary managed float -

Latvia fixed peg within ERM II since 02 May 2005; unilateral commitment to narrower band of +/- 1%

Lithuania Currency board; ERM II since 28 Jun 2004; unilateral commitment to currency board

Malta Euro area Member State (since 1 Jan 2008) since 02 May 2005; unilateral commitment to maintain exchange rate at parity

Poland Inflation targeting; free float -

Romania Inflation targeting; free float -

Slovakia Euro area Member State (since 1 Jan 2009) from 28 Nov 2005 to 31 Dec 2008 (standard +/-15% band) Slovenia Euro area Member State (since 1 Jan 2007) From 28 Jun 2004 to 31 Dec 2006 (standard +/-15% band)

Source: Commission services

managed or free floats, although they have taken different paths to reach their current regime. The 4.2. PROGRESS IN NOMINAL

Czech Republic and Poland have been operating CONVERGENCE: 5 YEARS ON explicit inflation targeting since 1998. Although the central banks in both countries initially This section provides a bird's eye view on the missed inflation targets by large margins (Jonas state of nominal convergence in the new Member and Mishkin, 2003), stronger implementation States in terms of price stability, public finances, and further refinements to the monetary policy exchange rate stability and pong-term interest frameworks contributed in the early 2000s to rates. Since 2004, in line with the requirement disinflation and stabilisation of inflation at low based on Article 122(2) of the Treaty, the levels. Romania moved to an inflation targeting Commission services and the ECB have prepared regime as of August 2005, after moving three regular Convergence Reports on the

gradually from a strongly managed float towards progress made by all the new Member States ( 84 )

a more flexible one. In Hungary, the central bank in fulfilling their obligations regarding the operated a hybrid framework that combined an achievement of economic and monetary union. inflation target with a unilateral peg of the forint to the euro (with a fluctuation band of +/-15%). During the five years after enlargement, the In February 2008, the exchange rate bands of the progress in nominal convergence has remained forint were abolished. quite diverse across the countries. While some of

them have made significant progress and joined The monetary and exchange rate strategies of the euro area, some of the others have made less Slovenia and Slovakia prior to adoption of the progress or have even backtracked. In some euro have differed somewhat from those of the cases this has implied a postponement of euro broad groups described above. Slovenia moved adoption plans (Box VII.4.1) Pursuing nominal from a crawling peg to a tight peg upon ERM II convergence faces additional challenges in the entry. The Slovak monetary policy framework current financial crisis environment; while (introduced in 2004), based on explicit inflation inflation is coming down rapidly in most targeting and tolerance of exchange rate countries, fiscal balances, exchange rates and appreciation, appears to have contributed to low inflation expectations and successful disinflation.

In November 2005, the Slovak koruna entered the ERM II with a standard fluctuation band of ( 84 ) The convergence assessments in May 2004, December +/-15%. 2006 and May 2008 also covered Sweden. Denmark and

the United Kingdom have not yet expressed their wish to adopt the single currency. The Commission and the ECB have also prepared convergence report in response to the requests by Slovenia and Lithuania (May 2006) and Malta and Cyprus (May 2007). Bulgaria and Romania were assessed for the first time in May 2008.

European Commission

Five years of an enlarged EU

Box VII.4.1: Euro adoption plans of the new Member States

The new Member States have chosen different Poland had not set an official target date for euro euro adoption strategies over last five years, adoption after it joined the EU,although recently notably shaped by country-specific the government announced the intention of characteristics. The road to the euro has been adopting the euro in 2012. The Czech Republic designed according to preferences of the has called-off the initial 2009-2010 target date, countries themselves, while reflecting monetary due to lagging fiscal consolidation and lack of and exchange rate strategies as well as the degree progress in "economic preparedness" (Czech of nominal convergence. National Bank, 2008). Among the most recently acceded EU Member States, Bulgaria aims at As regards the public announcement of euro euro adoption as soon as conditions permit; target dates, several new Member States publicly Romania's approach, by contrast, seems more announced concrete target dates for introducing gradual at this juncture. In the light of the recent the euro over the last five years, in particular as a global financial crisis, the discussions on euro supplementary instrument to anchor expectations adoption plans are gaining momentum again in and focus policy efforts. In 2004, the Baltic some new Member States (e.g. Hungary and countries and Hungary were at the forefront of Poland). NMS striving to introduce the euro at an earlier stage. The successful euro area entrants Slovenia Table 1: Intentions for euro adoption

(2006), Cyprus and Malta (2008) and Slovakia Bulgaria Aims to adopt the euro as soon as possible

(2009) had pre-announced target dates for euro The latest update of the "Czech Republic's

adoption in due course. At the current juncture, euro area accession strategy" from August

however, the intentions for euro adoption have Czech Republic 2007 states that some of the preconditions needed for benefiting from the adoption of the

been amended in a number of cases (Table 1). All euro have yet to achieve satisfactory three Baltic countries had to decide to postpone parameters. the timetable in the course of 2006-2007 in view Estonia Aims to adopt the euro as soon as possible of difficulties in meeting the convergence The most recent update of the Convergence

criterion on price stability. In Hungary, the earlier Hungary Programme does not contain any desired euro 2008 and 2010 targets were abandoned in view of area entry date. the difficulties encountered in achieving nominal Latvia Aims to adopt the euro as soon as possible convergence, notably due to substantial fiscal

slippages. Hungary has currently severe Lithuania Aims to adopt the euro as soon as possible

difficulties in meeting any of the convergence Poland Aims to adopt the euro in 2012

criteria, as diagnosed in the May 2008 Romania Not before 2014 Commission services' Convergence Report. Other Source: ECB (2008), Ministry of Finance in Poland

countries have been more circumspect about their euro adoption intentions.

long-term interest rates are negatively affected adjustments in indirect taxes). Price pressures by the current financial turmoil. moderated somewhat in 2005, but inflation subsequently rebounded strongly across most of Developments in consumer price inflation across the new Member States. The Baltic countries the new Member States have shown a mixed have seen a steep increase in inflation, in picture over the past few years (Graph VII.4.1). response to demand pressures and increasing Most of them saw HICP inflation slow capacity constraints. In Hungary, increases in considerably in the run-up to EU membership, indirect taxes and administered prices, as part of down from the double-digit figures often the necessary fiscal consolidation, contributed to registered until the late 1990s. In 2004, HICP a sharp increase in consumer prices. Inflation in inflation picked up temporarily across the Bulgaria recorded a sustained upward trend

acceding Member States partly as a result of amidst strong demand and wage growth. price effects related to EU entry (e.g.

Chapter VII

Enlargement and the EU policy framework

Graph VII.4.1: Inflation criterion in the new Member States economic downturn have contributed to a

16 %, 12-month movi ng ave rage relatively pronounced drop in headline inflation

across the new Member States, and weak cyclical

14 Range conditions are likely to keep inflationary

12 Re fe re nce pressures at bay for some time.

val ue 10 HIC P

8 The fiscal position of the new Member States has

improved considerably over the past five years,

6 although substantial differences continue to

4 persist across countries (Graph VII.4.2). Rapid

2 economic growth and the enforcement of fiscal

rules within the framework of Stability and

0 Growth Pact contributed to strengthening of

-2 fiscal performance. On one side of the spectrum,

04 05 06 07 08 the Baltic States have low debt levels and

Source: Commission services relatively contained public deficits or surpluses

(as Bulgaria has, too), even though in some cases Romania succeeded in achieving rapid the fiscal stance ought to have been tighter given disinflation, although HICP inflation accelerated the advanced stage of the cycle. In 2007-2008, again sharply in 2007. Cyprus and Malta have the Excessive Deficit Procedures of several new had a longer-standing tradition of relatively low, Member States (the Czech Republic, Poland, albeit at times volatile, inflation. In some Malta, Slovakia) were abrogated. Hungary has countries, exchange rate appreciation contributed been a fiscal outlier among the new Member to dampening pressures (in the Czech Republic, States, with high deficits and an increasing Poland, Slovakia and until mid-2007 also in government debt ratio. Looking ahead, the Romania). From the second half of 2007 ongoing economic downturn will place a heavy onwards, all the new Member States saw a burden on public finances in the new Member relatively sharp increase in inflation amidst rising States, which will to manage fiscal policy in a energy and food prices. way that cushions the downturn (depending on

the available fiscal space, which is curtailed in Graph VII.4.2: General government balance and debt in the new some new Member States in view of

Member States accumulated imbalances and vulnerabilities),

4 % of GDP while ensuring that public finances remain on a

BG sound footing over the longer term.

2 C Y

EE As regards exchange rate stability (Graph

0

SI VII.4.3), membership in ERM II has been mostly

LV C Z MT smooth for the participating new Member States.

-2 LT SK With the exception of the Slovak koruna,

RO PL currencies have traded continuously at or close to

-4 HU their central rates in the mechanism and shortterm

 interest rate differentials vis-à-vis the euro

-6 2008 have generally been small. The Slovak koruna 2004 followed a strong appreciation trend against the

-8 De bt as % of

0 20 40 60 80 background of sustained FDI-driven increases in

relative productivity, leading to revaluations of

Source: Commission services the central parity in March 2007 and May 2008.

In some of the new Member States (e.g. Latvia),

Slovakia was the exception within the group, the increased risk perceptions by markets have with developments in inflation on the whole led to a widening of short-term spreads since late being more favourable than elsewhere, partly due 2007 (European Commission, 2008e).

to the trend appreciation of the koruna. More recently, lower commodity prices and the

European Commission

Five years of an enlarged EU

Graph VII.4.3: Euro exchange rates of the new Member States Graph VII.4.4: The interest rate criterion in the new Member States

105 Jan 2004=100

C ZK 14 %, 12-month movi ng ave rage

100

PLN

12

95 SKK

RO N 10

90

85 8

80 6

75 4 Range Re fe re nce val ue

70 Long-te rm i nte re st rate (ave rage )

04 05 06 07 08 2 04 05 06 07 08

108 Jan 2004=100

EEK C YP LVL LTL Source: Commission services

106 HUF MTL SIT BGN

104 The new Member States witnessed a spectacular

102 convergence of long-term interest rates already

prior the EU accession (Graph VII.4.4), although

100 some degree of country-specific diversity

98 persists across the group. In particular, tight pegs 96 and currency boards were associated with advanced interest rate convergence. Closely

94 related to exchange rate stability and inflation

92 convergence, interest rate spreads – driven by 90 expectations – came down to even narrower 04 05 06 07 08 levels in the new Member States set to adopt the

Source: ECB and EcoWin euro, sometimes already well in advance of euro

adoption. Countries with an unfavourable initial

The non-ERM II currencies which had floating position (Romania and Poland) also benefited rates showed a broadly appreciating trend over significantly from the compression of risk the last five years, with the exception of the premia. Hungary remained the exception within

Hungarian forint (in the context of the unilateral the group, with both money market and longwide-band peg). The exchange rates of the Czech term spreads remaining at high levels, reflecting koruna and Polish zloty, in particular, followed a concerns about extensive fiscal imbalances in strong appreciation path. The Romanian leu particular. Over the last year, tighter global appreciated from 2004, but the previous gains financing conditions and lower risk appetite have were partly corrected from mid-2007 onwards in led to a general widening of both short- and view of growing concerns among investors about long-term spreads among the new Member the widening imbalances in the economy. States, though the impact has been particularly Uncertainties on the exchange rate outlook in the pronounced for those countries that have region have sharply increased in recent months, accumulated large external imbalances and

as a global retreat from risk contributed to a vulnerabilities.

correction across the floating currencies of the

new Member States, which remain vulnerable to The Treaty (Article 121) requires an examination

global market sentiment. of other factors relevant to economic integration and convergence. These additional factors

include financial and product market integration and developments in the external balance. The next section presents some stylised facts that are

also relevant to these areas.

Chapter VII

Enlargement and the EU policy framework

4.3. CHALLENGES OF THE EURO an environment of robust trend growth over the

CONVERGENCE PROCESS last years, necessary to achieve real convergence, accompanied by price level convergence and

A number of studies (e.g. Schadler et al., 2005; equilibrium real exchange rate appreciation.

European Commission, 2008d) support the Secondly, the five years after enlargement have notion that the potential benefits from euro area shown that, compared to previous convergence participation for the new Member States as a episodes, the catching-up process of the new group are significant, contributing positively to Member States is embedded in a new long-term growth and stability. Euro adoption environment of globalisation and financial impacts on economic performance through a integration (Szekely and Watson, 2007). Their number of macroeconomic and microeconomic relatively small size, high degree of openness channels; these include adoption of a stabilityand rapid financial deepening make the new oriented macroeconomic framework, access to Member States prone to the effects of external liquid markets, more trade and foreign direct shocks. These risks have become particularly investment, lower transaction costs and increased apparent in the current context of the global competition. financial crisis, when the retreat from risk and

search for liquidity by investors is contributing to Nonetheless, euro adoption entails major heavy pressures on the financial markets of the economic changes and the requirements for new Member States. successful participation in the single currency area are demanding. This suggests that the policy These two specific challenges faced by the new debate on euro area membership should be based Member States, examined from the viewpoint of on broader aspects than just on a static view on (prospective) euro area entry, are discussed the state of nominal convergence (Angeloni, Flad below. and Mongelli, 2007). In order to reap the full

benefits of the single currency, in the absence of 4.3.1. Price level and real convergence

a national monetary policy and under an irrevocably fixed exchange rate, economic policy Most of the new Member States have emerged needs to ensure the proper functioning of internal from a transition process and are still catching up adjustment mechanisms to safeguard stability. In in relation to the euro area in terms of relative particular, adequate labour and product market income levels. Impressive progress in flexibility and sufficient fiscal buffers are macroeconomic stabilisation and comprehensive identified as the main challenges with regard to supply-side reforms, accentuated by the EU euro preparedness (Rybinski, 2007; Czech accession process, have enabled most of them to National bank, 2007; National Bank of Poland, advance with income convergence at a robust 2004; Darvas and Szapáry, 2008). Also, closer pace over the past five years, although diversity integration with the euro area economy should among countries is still wide (see also Chapter help to reduce vulnerability to asymmetric II.2). In the short term, the new Member States shocks. In this respect, macroeconomic will have to deal with the fall-out from the developments over the past five years suggest financial crisis, including a sharp downturn in some progress in the alignment of economic growth. Indeed, some countries which have gone structures of the new Member States with the through an impressive catch-up process over the euro area (Box VII.4.2), even though they are a past years (e.g. the Baltics) have entered heterogeneous group. recessions, and growth in the region may remain

slow for some time. Against this background, However, the specific circumstances of the new completing real convergence is likely to remain a Member States do tend to accentuate certain major factor shaping economic policy strategy convergence-related risks (see also Chapter for most of the new Member States over the IV.2). Countries that have built up large medium term, within or outside monetary union. domestic and external imbalances over time are particularly vulnerable in the current context of financial crisis. First, most of them have (as compared to the old Member States) operated in

European Commission

Five years of an enlarged EU

Box VII.4.2: The theory of Optimum Currency Areas and the new Member States

The literature on Optimum Currency Areas Overall, the results point to a decreasing (OCA), pioneered by Mundell (1961) and susceptibility to asymmetric shocks in the years McKinnon (1963), identifies well-known after EU enlargement, though the results are conditions under which a country would be country-specific and due caution is warranted in expected to be able to renounce its own monetary interpreting estimation results in view of short data

policy. These include (i) business cycle coseries and possible structural breaks (Chapter VI). movement and convergence of economic

structures (minimising the risk of asymmetric - Sectoral structures of the new Member States are shocks), (ii) well-functioning adjustment becoming more closely aligned with the euro area mechanisms developed to cope with possible over the longer-run, though some differences shocks (labour and product market flexibility, remain also after EU accession. While agriculture fiscal capacity). More recent versions of the loses ground in most of the new Member States, in Optimum Currency Areas approach also line with continuing catching-up, their economies highlighted (iii) the degree of financial integration generally still show a higher share of industry and as an indicator for the capacity of the economy to fewer services than in the euro area (Chapter VI;

smooth out shocks. Although this approach has European Commission, 2008d).

been criticised for a number of reasons, it provides Relatively large differences remain among the new a useful conceptual framework to look at the Member States in terms of the effectiveness of potential enlargement of the euro area. domestic adjustment mechanisms that would play

The degree of alignment of economic structures to a key stabilisation role within monetary union:

the euro area has increased for the new Member - Measures of labour market flexibility tend to States , though a significant degree of countryshow the new Member States in a better position specific diversity persists: than the old Member States, which in turn would

• - 

  As far as trade flows are concerned, the new make them adjust more easily to asymmetric Member States were relatively well integrated shocks in a monetary union (Chapter VII.2). As with the broader EU and euro area economy compared to the euro area, the degree of already before EU accession, starting with the employment protection legislation (EPL) appears signature of bilateral Preferential Trade as less stringent in the four Visegrad countries for Agreements. Empirical evidence by Fidrmuc which data OECD are available. However, the (2005), using a gravity model, found that there evidence suggests that progress in labour market was limited room left to increase market shares for flexibility across the new Member States over the the new Member States in the post-accession past five years has been uneven. Persistently high period, in particular for the larger countries. For structural unemployment and low employment most of them, even when the pace of trade rates in some new Member States point to integration slowed down as compared to the period weaknesses in the allocation of labour market of transition in the 1990s, trade ties with the euro resources, while sectoral and regional labour area have developed further over recent years mobility often appears insufficient to cope with

  (Chapter III.1). potential shocks (European Commission, 2008d).

  • - 

    There is evidence that business cycle - Fiscal positions have improved considerably synchronisation between the new Member States since EU accession. Nonetheless, the degree to and the euro area has increased over the medium which fiscal policy can be an effective instrument to long run (Darvas and Szapary, 2008). The to smooth out asymmetric shocks depends also

  picture is, however, more diverse at the country on the structure and quality of public finances level, where the analysis suggests that the cyclical (Chapter VII.4.3; European Commission, 2008g). alignment in some cases (e.g. Slovakia and Slovenia) exceeds the level of some old Member States, while the correlation of business cycles visà-vis the euro area is lower e.g. in the Baltic countries (Fidrmuc and Korhonen, 2006).

Chapter VII

Enlargement and the EU policy framework

Graph VII.4.5: Catching-up and price level convergence in the rules out the nominal exchange rate channel of

new Member States real appreciation, which implies a higher trend

90 GDP pe r capita i n PPS (e uro are a = 100) inflation for converging economies than for the

anchor area.

80 SI

C Y

C Z

70 Graph VII.4.6: Income and price level convergence at euro entry

MT in convergence countries

EE

60 SK 120

HU Pri ce l e ve l (house hol ds fi nal consumpti on) LV

50 LT Income l e ve l (GDP pe r capita i n PPP) PL 2007 100

1999

40

BG RO 80

30 Pri ce l e ve l

(house holds fi nal consumpti on e uro are a = 100) 60

20 30 40 50 60 70 80 90 40

Source: Commission services

20

Economic catching-up tends to be coupled with a convergence of price levels (Graph VII.4.5). 0

Price levels in the new Member States are still BGC Z EE LV LT HU PLRO C Y MT SI SK IE EL ES PT

considerably lower than the euro area average, Note: Euro area Member States: year of euro adoption; other: 2007

although significant differences remain across Source: Commission services

the individual countries. The price level gap

remains particularly pronounced for services, One underlying driver of price convergence is where prices are on average well below half of the well-known 'Balassa-Samuelson effect', the EU-15 level, compared to around two-thirds which postulates that wage-induced inflation in for goods (European Commission, 2008d). A the non-tradable sector stems from productivity snapshot of current levels of prices and incomes differentials between tradable and non-tradable across the new Member States also compares sectors (Egert, 2007). However, the empirical unfavourably with the "convergence" countries evidence on the extent of the Balassa-Samuelson (Greece, Ireland, Portugal and Spain) at the time effect is not conclusive and a survey of most of their euro area entry. That said, the gap in recent studies suggests an impact on inflation of incomes and price levels between the new below one percent for most new Member States Member States currently participating in the euro (European Commission, 2008d).

area (Cyprus, Malta, Slovakia and Slovenia) and

"convergence" countries appears somewhat Other factors also have a significant impact on narrower on average, although it does mask the dynamics of real appreciation. First, the country-specific differences (Graph VII.4.6). speed of income convergence, domestic demand

growth in excess of GDP growth and the

Theory suggests that equilibrium real exchange exchange rate regime have a significant rate appreciation (price level convergence) is a explanatory power in the determination of price natural consequence of economic catching-up level convergence dynamics (Darvas and (De Grauwe and Schnabl, 2005). Depending on Szapáry, 2008). Over a shorter time horizon, the monetary strategy and exchange rate regime, some factors - such as the degree of cyclical appreciation real exchange rate can occur in one synchronisation, movements in nominal of two ways (or a combination of them), namely exchange rates and the differing impact of through an appreciating nominal exchange rate swings in global commodity and food prices - and/or higher domestic inflation. The speed and may draw inflation rates temporarily away from channels of equilibrium real appreciation in a underlying trends in price level convergence. catching-up context thus have a bearing on the Some structural factors may also work towards trajectory of nominal convergence. A fixed lowering inflation in catching-up EU Member exchange rate regime (e.g. the Baltic countries), States, for instance the impact of trade

European Commission

Five years of an enlarged EU

liberalisation, dampening import prices and Graph VII.4.7: Sovereign debt ratings in the new Member States,

enhancing competition on product markets. 2000-2008

S&P, fore i gn curre ncy, long te rm

Secondly, not all inflation differentials under 2000 2002 2004 2006 2008

catching-up are consistent with ensuring

competitiveness and external stability of the AA AA-

economy over the medium term. In some A+

countries, high inflation has been driven by A A-

unsustainable demand growth, fuelled by BBB+ BBB

excessively optimistic future expectations of BBB-

economic agents and/or inappropriate economic BB+ BB

policies. BB-

B+ B

4.3.2. Convergence dynamics in the "post B-

accession" environment BG C Y C Z EE HU LV LT MT PL RO SK SI

The strong growth dynamics of the new Member Source: Bloomberg

States have often been accompanied, and

sometimes driven, by rapid financial deepening The Member States with tight pegs and currency and credit expansion (see also Chapter IV.2). At boards have received larger capital flows on the same time, financial integration of the new average (as a percentage of GDP), including Member States into the broader EU financial FDI, than floating-currency countries and they sector has also advanced strongly in recent last have run higher current account deficits years. The new Member States have in particular (European Commission, 2008d). The 'fixers' been able to mobilise foreign savings on a large have been also associated with more advanced scale in a context of real convergence and high interest rate convergence, often implying returns on investment. negative real interest rates (Graph VII.4.1) on

account of particularly steep inflation and very

Both short-term and long-term interest rates rapid credit growth. As an additional factor, it across the new Member States have converged needs to be noted that the 'fixers' among the new significantly towards euro-area levels in recent Member States generally started their real years (Graph VII.4.4). Interest rate convergence convergence process from lower output levels, has partly reflected a favourable global potentially implying higher returns on capital, environment, but has been accentuated by and therefore an incentive for larger capital confidence gains in the context of EU accession. inflows, in the earlier phases of catching-up

Joining the EU and prospects of single currency (European Commission, 2008d).

pushed risk premia further down as it provided a

strategic focus and an "umbrella" for credible The rapid progress in financial integration of the economic policies that was lacking in other new Member States is in principle a sign of well(emerging market) regions. The improvement in functioning European financial market and is country risk perceptions across the new Member conducive to a more efficient allocation of States in the years before and after EU accession resources. However, managing rapid financial was mirrored in a steady improvement of deepening and large capital inflows can be a sovereign risk ratings. However, more recently challenge (Babecký, Bulíř and Smídková, 2009). credit ratings have been downgraded for some of The rapid growth of credit and the allocation of the new Member States in the context of global capital inflows towards nontradable sectors financial turmoil (Graph VII.4.7), while risk (notably real estate) may alter the composition of perceptions increased more generally. final demand and, as a result, lead to

considerable movements in the real exchange rate. Real appreciation (and also external deficits) may become excessive as a result of unduly optimistic expectations by economic agents and/or inappropriate policies (Boz, 2007).

Chapter VII

Enlargement and the EU policy framework

Graph VII.4.8: Real short-term interest rates in the new Member States have started from diverse initial conditions

States and have, over the last five years, pursued

7 %, 3-month inte rbank i nte re st rate s various strategies tailored to their own capacities

de fl ate d by core HIC P

5 and needs. Policies to prepare for participation in

the euro area should take a forward-looking 3 view, aiming to underpin the sustainability of

1 convergence. In particular, the fact that

convergence of the new Member States is taking -1 place in a new environment characterised by -3 globalisation and financial integration, has

important implications for policy makers in

-5

May-04 Jul-08 terms of achieving and sustaining nominal

-7 convergence.

-9

EA BG C Z EE LV LT HU PL RO SK In the nearer term, the main challenge is to deal

with the fall-out from the financial crisis.

Source: Eurostat, Commission services Countries that have built up large domestic and

external imbalances are more vulnerable in the

An 'overshooting' of the real exchange rate may current environment of global financial turmoil. hinder the achievement of fast and sustainable They will have to endeavour to manage an nominal convergence and create additional orderly unwinding of these imbalances. This hurdles on the path towards the euro. requires efforts to mobilise the full range of Furthermore, growing imbalances pave the way domestic policy instruments. A well-balanced for a potentially painful macroeconomic macroeconomic policy mix and a responsible correction in the years ahead. Credit growth has wage policy are necessary in order to avoid a recently eased across the new Member States in potentially painful macroeconomic correction in the context of the global financial crisis. This has the years ahead. On the macro-prudential reflected tighter liquidity conditions as well as dimension, strong financial supervision is needed higher risk awareness by lenders and borrowers in order to ensure the proper functioning of (see also Chapter IV.2). In these exceptional financial sectors. It remains crucial for all circumstances, financing conditions have Member States to keep progress towards deteriorated particularly in countries that have convergence and not to derail policy efforts.

built up large domestic and external imbalances

and where foreign currency lending has been Taking a longer-term view, it is vital to focus common (i.e. in the Baltic States, Bulgaria, policies firmly on the working of internal Hungary and Romania). adjustment mechanisms and on the macroprudential

 dimension in order to fully reap the benefits that the single currency can provide.

4.4. CONCLUSIONS Domestic factor and product markets must be

flexible enough to ensure a smooth adjustment to

Since the 2004 enlargement, four new Member economic and financial shocks. Prospective euro

States have fulfilled the necessary conditions for area entrants also need to strive for further adopting the euro and have joined the euro area. progress in fiscal and structural policies along Other new Member States have made some the lines of the SGP (and possibly beyond) and progress in nominal convergence and their the Lisbon agenda.

economic structures also appear to have converged towards that of the euro area, although there remains a significant degree of countryspecific diversity across the group.

There is no single, optimal path towards the euro that can be identified and recommended to all countries at all times. The twelve new Member

• 5. 

  THE ROLE OF EU TRANSFERS

Member States benefit from significant transfers 5.1. TYPES AND VOLUMES OF EU TRANSFERS from the EU budget, to support the various EU

policy areas. About one third of the EU budget is 5.1.1. Main types of EU transfers

channelled through the Structural and Cohesion

Funds, which aim to stimulate the EU expenditure is predetermined in a multicompetitiveness of regional economies and to annual financial framework, known as the help the areas lagging behind to catch up more Financial Perspective, which sets out the quickly. The Common Agricultural Policy maximum spending for each main budget (CAP), which accounts for roughly half of the category per budget year. For the period 2000- EU budget, provides income support to farmers, 2006, these amounts were fixed in the Financial as well as assistance to the restructuring of the Perspective 2000-2006, which was later amended agricultural sector and rural development. by the "Copenhagen Package", specifying the

amounts allocated to the Member States which Yet, the accession of twelve new Member States, joined in 2004. The current Financial with per capita incomes (in PPS) at about 54% of Perspective, covering the period from 2007 to the EU-15 average on the date of accession and 2013, allocates transfers to Member States under with a large agricultural sector, has triggered a various policy areas and related budget

lively debate on the sustainability of the existing headings ( 85 ).

transfer mechanisms. On the one hand, some of the main beneficiaries in the old Member States The aim of "cohesion for growth and jobs" is to uttered concerns about losing access to funding. promote three objectives: (i) convergence, (ii) On the other hand, concerns were voiced about regional competitiveness and employment, and the absorption capacity of the new members and (iii) European territorial cooperation. They the long-run impact of EU funds on growth. mainly target the least developed Member States

and regions. For example, the "convergence This analysis regards the availability of EU funds objective" only covers regions with a GDP per as a unique opportunity for the new Member capita of less than 75% of the EU average. The States to speed up the process of catching up principal financing instruments are the two with EU living standards. Yet, their potential Structural Funds, namely the European Regional leverage on long-run growth will crucially hinge Development Fund (ERDF) and the European on the quality of the domestic policy Social Fund (ESF) plus the Cohesion Fund (CF). environment and institutions, both in terms of These funds mainly finance investments in macroeconomic and fiscal policy management infrastructure, human capital and R&D. A small and in terms of individual project selection. part of the funds (less than 5%) is channelled as

direct aid to companies. The policy area of The first part of this section gives an overview of "cohesion for growth and jobs" has become one the main types and volumes of EU transfers. The of the principal instruments for the delivery of second part focuses on the Regional and the Lisbon agenda.

Cohesion Policy. It briefly examines the economic rationale for EU transfers, discusses The bulk of the funds under the "natural the issue of absorption capacity and reviews both resources" heading is spent on the Common theoretical insights and the empirical evidence Agricultural Policy. It covers expenditure for available on the long-term impact of these market measures and direct payments to farmers transfers on growth. The third part deals with the financed through the European Agricultural impact of transfers related to the Common Guarantee Fund (EAGF), as well as for rural Agricultural Policy.

( 85 ) This section focuses on transfers, i.e. EU expenditure

that flows back to Member States. They cover between 85% and 90% of the total EU budget. The remaining expenditure consists of, among others, transfers to third

countries and administration (e.g. Commission services).

Chapter VII

Enlargement and the EU policy framework

development financed through the European 5.1.2. EU transfers in perspective

Agricultural Fund for Rural Development

(EAFRD). Furthermore, the area of "natural In 2007, total transfers from the EU budget to the resources" also includes the European Fisheries Member States amounted to €99.2bn, or 0.8% of Fund (EFF), which provides support for EU-27 GDP. The policy areas of "cohesion" and economic adjustment in the fisheries sector and "natural resources" represent the bulk of this fisheries regions ( 86 ). amount (Graph VII.5.1). While the former

covered about 37% of all transfers, the latter

During the first three years following accession, accounts for slightly more than half of all the EU budget also includes "compensations" to resources, of which ¾ was channelled as direct cover specific areas. In particular, the "Schengen payments to farmers.

Facility" and "Cash Flow Facility" respectively

finance actions at the new external borders of the Graph VII.5.1: Total transfers to the Member States in 2007

Union (implementation of the Schengen acquis)

and provide funds to safeguard a positive cash C i ti z e nshi p The EU as a , fre e dom,

flow in the national budgets upon accession. In gl obal se curi ty and

addition, the "Transition Facility" aims to playe r (EU justice ; C ompe titi ve - 10); €1.5bn €1.0bn ne ss; €5.5bn

strengthen the administrative capacity to C ompe nsati (1%) (1%) (6%)

implement and enforce Community legislation. ons (BG, RO );

€0.4bn (0%)

Furthermore, when assessing the volumes and C ohe si on;

impact of EU funds, it is also relevant to point €36.9bn Natural (37%) out that Member States benefited from specific re source s; €53.9bn

assistance programmes long before accession, (54%) with the objective of helping them introduce the necessary political, economic and institutional transfe rs i n bn e uro (% of total ) reforms in line with EU standards. All preaccession

 financial instruments are grouped Source: Commission services

under the budget heading "the EU as a global

player"; the main instruments are PHARE In terms of geographical distribution, the new

(strengthening public administration), ISPA Member States received about 20% of all

(financing investments in transport and transfers in 2007. In line with the country infrastructure) and SAPARD (financing rural and allocations in the Financial Perspective 2007- agricultural development projects) ( 87 ). 2013, this share will gradually increase up to an

average of 35% (by way of comparison, the new

Lastly, Member States can also apply for funding Member States represent 20% of the EU-27 for specific projects in the area of population and 7% of the EU-27 GDP; Graph "competitiveness" (e.g. in the fields of lifelong VII.5.2). In the policy area "cohesion for growth learning, transport of energy) and "citizenship, and jobs", the EU-12 will actually receive freedom, security and justice". roughly half of all transfers to Member States,

reflecting the greater needs of this group in the catching-up process. As regards the CAP, the EU-12 countries will receive 14% of the EU funds for direct payments and 42% of the EU funds for rural development.

( 86 ) Transfers under the Common Fisheries Policy are not

further considered since they will make up less than 2% of the funds under the heading "natural resources" in the new Member States within the Financial Perspective 2007-2013.

( 87 ) Since 1 January 2007, the 3 preaccession financial

instruments, together with specific instruments for Turkey and the Western Balkans, have been grouped under the "Instrument for Pre-accession Assistance".

European Commission

Five years of an enlarged EU

Graph VII.5.2: Regional distribution of EU transfers, 2007-2013 Member States (European Commission, 2004).

100 % of total As a result of the phasing-in approach, the EU

funds will be allocated almost equally between

80 rural development and direct payments in the

new Member States within the current Financial

60 Perspective 2007-2013 (Graph VII.5.4), unlike

the situation in the old Member States where

40 more than 80% of the funds will be spent on

direct payments.

20 Graph VII.5.4: EU budget expenditure for direct payments and rural development in the new Member States,

0 2007-2013

L D F n T A D

F , R D P

R F E

F F G

ti o G 9 T O C

F Bn. €

F , E E A E

A

u la E S NMS O MS 8

Rural De ve l opme nt (ERDF)

P o

p

Di re ct Payme nts (nati onal ce i li ngs)

Note: EAGF : preallocated direct payments only, excluding market 7

expenditure

Source: Commission services 6

5

In this context, it is also relevant to highlight the 4

fact that some EU funding to the new Member

States is phased-in gradually. This applies to 3

funds committed under the policy area 2 "Cohesion for growth and jobs", which will 1 gradually increase over time (Graph VII.5.3). At

the same time, the share allocated to the EU-15 0 07 08 09 10 11 12 13

will decrease by about one quarter relative to

their average level for 2000-2006. Source: Commission services

Graph VII.5.3: Phasing-in of funds in the area of cohesion for Although the amounts transferred are significant

growth and jobs from the point of view of the EU-12, they cannot 35 be regarded as an unbearable burden from the

Bn. €, commi tme nts of ERDF, ESF and C F perspective of the old Member States. In 2007, a

30 NMS O MS total of about €17.8bn has been transferred to the new Member States, representing 2.1% of the

25 EU-12 GDP, which -although it is significant

20 represents only 0.2% of the EU-15 GDP. Even

after the phasing-in period, transfers to the new 15 Member States would increase to an estimated

3% of GDP by 2013, while the impact on the old 10 Member States would increase only slightly to

0.3% of GDP.

5

0 As from the date of accession, new Member

04 05 06 07 08 09 10 11 12 13 States also contribute to the EU budget. On

Source: Commission services average, in 2007, the VAT- and GNI-based resources ( 88 ) and the share in the financing of

Direct payments to farmers are also being the UK rebate accounted for just under 1% of

gradually phased in, starting with 25% of the EU-15 level in 2004 and reaching the full rate of

EU-15 payments in 2013. The new Member ( 88 ) The "traditional own resources" consisting of agricultural

States may top up the EU funds by national duties, sugar levies and customs duties on extra-EU

payments, but only up to the level in the old imports are not included in the national contributions as they cannot be assigned to Member States individually.

Chapter VII

Enlargement and the EU policy framework

GNI ( 89 ) for all 27 Member States. Yet, on 5.2. REGIONAL AND COHESION POLICY

balance, the new Member States are net

beneficiaries of EU transfers. In 2007, net 5.2.1. The rationale of EU Structural and

transfers ( 90 ) to the EU-12 were equivalent to Cohesion Funds

1.3% of their GNI (Graph VII.5.5). In 2007, the old Member States were -on average- net Before starting to assess the economic impact of contributors to the EU budget by about 0.1% of EU transfers, this paragraph describes the their GNI. rationale for such policies. A distinction has to

be made between the policy area of "cohesion for Graph VII.5.5: Net EU transfers and GDP per capita in 2007 growth and jobs", the main aim of which is to

250 GNI pe r capita (PPS, EU27=100) boost economic growth and foster cohesion by providing investment support and the area of

LU "natural resources", which principally provides

200 sector-specific assistance to the development of

rural and fisheries regions through direct income 150 and investment support. This section will focus

NL IE on the former, whereas the latter will be

DE ES

100 discussed in section 5.3. C Y S I PT EL

MT EE

50 SK HU Legal framework

PL LV LT

RO BG

Ne t EU transfe rs (% of GNI) A basic reference for the rationale of the

0

-1 0 1 2 3 4 cohesion policy is Article 158 of the Treaty,

which states that, "in order to strengthen its

Source: Commission services economic and social cohesion, the Community is

to aim at reducing disparities between the levels

The importance of EU transfers for the new of development of the various regions (…).

Member States is also evident from their relative Cohesion policy should contribute to increasing share in public sector gross fixed capital growth, competitiveness and employment (…)."

formation. In the recently acceded countries,

transfers under the policy area "cohesion for The disparities referred to in the Treaty may be a growth and jobs", which make up to the bulk of result of the accession of new, relatively poorer investment-related transfers, amounted to 25% of members, as was the case with the previous EU public gross fixed capital formation in 2007 accession and the earlier accessions of Ireland, (against roughly 12% in the old Member States). Portugal, Spain and Greece. These disparities

may also emerge from increased competition on world markets. Indeed, while more intense competition provides new opportunities for Member States and regions, at the same time it requires adjustment to structural change and management of its social consequences as well as better functioning of the internal market (European Commission, 2008a). Against this background, the Cohesion Policy aims to assist

( 89 ) The basis for calculating national contributions is poorer Member States or regions to catch up with

national income (GNI), as opposed to domestic other more prosperous areas, mainly by

production (GDP). Although the difference between both providing investment support. The following

is usually small, for some countries (such as Ireland and

Luxemburg), outward factor income generated by FDI paragraphs will summarize the main arguments

and/or border workers is significant, making GDP higher for public sector involvement in investment and

than GNI. will also highlight some of its limitations. ( 90 ) Calculated as the sum of all previously mentioned

transfers to the EU-27, minus the contribution to the EU budget (i.e. VAT- and GNI-based resources).

European Commission

Five years of an enlarged EU

Economic rationale Caveats concerning public investment

The economic underpinnings for the EU However, it must be stressed that there are also Cohesion Policy are based on the new economic important caveats to public sector involvement, geography as well as on the endogenous growth both when raising public funds and when theory. Therefore, location-based considerations allocating them across different investment around core-periphery relationships are projects. On the financing side, part of the combined with notions that the development and benefit of public investment might be eroded by the growth rate of economies crucially hinges on raising distortionary taxes. Also, government both (possibly external) capital transfers and intervention, when financed by raising funds on endogenously created R&D investment and the the capital market, may crowd out private

level of human capital as well as institution investment, through rising interest rates. building. With respect to the use of public funds to In this context, public intervention can be optimise growth, three main obstacles have been justified in three sets of circumstances. First, identified (for an overview: Hervé and market mechanisms may not lead to growth Holtzmann, 1998): (i) No increase in production maximizing allocation of investment in R&D and capacities, (ii) sub-optimal use of transfers and labour skills. For example markets characterized (iii) changing relative prices due to the inflow of by positive externalities may lead to undertransfers. investment by the private sector, as the benefits of an investment project may accrue not only to Problems of the first type emerge if not all the investor but also to society at large (e.g. in available funds are spent on projects to improve the area of R&D). Similarly, the fact that many the production capacity of a Member State or a types of investment involve public goods may region. Necessarily, part of the available money also constrain private sector investment, for is spent to cover administration costs related to example in the area of transport infrastructure. the planning and monitoring of projects. Under these circumstances, a well designed and Furthermore, external transfers may lead national coordinated public action can potentially bring governments to shift part of capital spending to the economy up to a higher growth path. current expenditure, in anticipation of the accrued benefits of externally funded Second, governments may also intervene if the investments (consumption smoothing). outcome of market mechanisms is not socially acceptable. In particular, actions may be taken to The second type of problems is the sub-optimal generate a fairer distribution of wealth across use of funds. For example, helping poor regions regions. In the presence of market failures, such by providing aid to declining industries may only as increasing returns to scale (e.g. in the context delay the necessary structural reforms and lead to of large fixed costs), factors of production may adverse consequences for their long-run growth concentrate in one particular region, leaving prospects. Furthermore, certain regional policy other areas at the periphery. This process might instruments can have adverse effects on the ultimately lead to further regional divergence. economies of catching-up regions. A classic Hence, governments may decide to stimulate example is investment in transport links between growth and employment creation in remote areas the core and periphery (Baldwin et al., 2003) by granting support to firms or by upgrading which, by lowering the cost of serving the labour skills in poorer areas. periphery from the prospering region, may lead to a further outflow of firms from the former. Third, the Cohesion Policy also aims to improve This perverse impact of better transport Member States' institutional capacity to manage infrastructure is, however, likely to be temporary public investment programmes. The principle of before a better spatial allocation of factors yield multilevel governance increases transparency, more growth. acceptance and accountability, through the involvement of civil society as key stakeholder. Finally, transfers may also cause shifts in relative prices. One example is the so-called Dutch

Chapter VII

Enlargement and the EU policy framework

disease, whereby the demand for factors in the against 91% for the old Member States). By non-tradable sector, boosted by the inflow of contrast, as compared to the four old cohesion transfers, leads to and upward pressure on wage countries (Greece, Ireland, Portugal and Spain), and price levels in this sector and to a decline of the pace of spending from the Cohesion Fund the tradable sectors. and ISPA was fairly modest for most new

Member States (52% versus 73%, Table VII.5.1). With a view of optimizing the use of EU This poorer performance by new Member States transfers, while limiting some of the risks suggests that the speed of spending will have to outlined above, disbursements are subject to the increase in the next years for Bulgaria, Hungary, following EU rules. First, Member States should Poland and Romania, in order to achieve full provide national co-financing for 15% of the absorption by the end of 2012, which is the last

total project cost ( 91 ). The aim of this year in which resources from the 2000-2006

requirement is to strengthen domestic ownership, Cohesion Fund can be paid to Member States. as Member States are obliged to contribute with On the other hand, the absorption level of several locally raised funds. Furthermore, EU transfers of the smaller new Member States is slightly should be considered as "additional", i.e. they are ahead of schedule. in addition to public capital expenditure. This principle is laid down to avoid instances of Table VII.5.1: Absorption rates in programming period 2000- national resources being shifted from capital to 2006

current spending. Finally, Member States should Structural Funds Cohesion Fund and ISPA

prioritize investment projects in multi-annual Absorption Absorption Amount spent Amount to be spent

programmes, the "National Strategic Reference Rate Rate per year per year 2004-2008 2008-2012 (2)

Frameworks", which highlight the priority areas (%) (%) (mio Euro) (mio Euro)

BG (1) na 40 58 132

for public investment and which indicate, inter CZ 91 66 141 104

alia how the funds will contribute to reaching the EE 95 68 51 34 CY 85 59 6 6

objectives of the Lisbon Growth and Jobs LV 95 71 90 51

strategy. LT 95 68 98 67 HU 94 55 133 165

MT 95 80 4 1 PL 94 54 499 651

5.2.2. Absorption of EU funds RO (1) na 52 181 248 SI 94 64 28 23

SK 95 70 96 57

The essential precondition for the EU cohesion NMS 94 57 1 436 1 539 OMS

91

and structural funds to achieve their objective of OMS (3) 73 1 631 1 254 enhancing real convergence across EU countries Note: (1) As Bulgaria and Romania joined in 2007, data refer to ISPA

and regions is that they are smoothly absorbed by only; (2) assuming a full absorption by the end of 2010 of the 2000- 2006 CF programming; (3) Only Greece, Ireland, Portugal and Spain.

their beneficiaries. The absorption performance Situation as at February 2009.

of a country is most often measured according to Source: Commission services

its "absorption rate", defined as the ratio of expost

amount of EU funds that have been spent to It must be stressed that Member States tend to the ex-ante spending targets. significantly accelerate their rate of absorption

towards the end of the period in which resources

As far as the funds for the 2000-2006 from a particular tranche of funds can be programming period are concerned (Table claimed. Indeed, this phenomenon has already VII.5.1) ( 92 ), the absorption of Structural Funds occurred for the 2004-2006 Structural Funds. has by both the new and old Member States has been shown a considerable increase every year since very similar (the rate of absorption being 94% the resources became available (Graph VII.5.6).

for the ten countries that joined in 2004, as

The relatively slow rates of absorption immediately after accession can be explained in

( 91 ) The new Financial Perspective 2007-2013 reduced the part by the natural project cycle: it takes time to

co-financing rate from 25% to 15%. prepare investment programmes and project

( 92 ) Spending of funds from the current programming period proposals, organize public tender procedures and

has not until now taken off for any of the EU-27 Member

States. Therefore the absorption rates for this period are start up the selected projects. The accelerating

not presented in the table. absorption profile may also reflect a slow but

European Commission

Five years of an enlarged EU

steady building up of the administrative and theoretical model, they try to establish an financial capacities of Member States. empirical link between the amount of transfers Nevertheless, given that the available structural and the output level, output growth, productivity,

and cohesion funds for the new Member States or productivity growth. will more than triple in the new financial perspective 2007-2013 as compared to the Whereas the model-based approach usually finds previous programming period, it is clear that this ample evidence of positive long-run supply represents a considerable challenge as regards effects (Box VII.5.1), the regression-based their administrative and institutional capacity. analyses yield a more mixed picture, depending on the time period considered, the regions or Graph VII.5.6: Structural funds (ERDF and ESF): absorption in countries included in the sample and the

2004-2008 estimation techniques. The positive outcome of

45 2004 2005 2006 2007 2008 the first approach may be due, at least in part, to 40 % of total commi tme nts the underlying assumption of optimum use of the available resources (no diversion of funds to

35 consumption, optimal selection of projects, etc.).

30 In contrast, the more moderate outcomes of the 25 latter approach may be due to several factors. On the methodological side, they can be explained in

20 part by the difficulty of measuring the long-run

15 effect of EU funds and singling it out from 10 amongst the many other factors that affect

5 growth. Yet, they also reflect that the funds are

sometimes used to pursue a variety of goals that

0

C Y C Z EE HU LT LV MT PL SI SK are not strictly compatible with the growthenhancement

objective.

Source: Commission services

A number of broad policy messages emerge from

5.2.3. The impact of EU funds these studies. First, the general rule is that the

larger the share of funds used for investment (as

Even a full absorption of EU structural and opposed to consumption or direct income cohesion funds will not – of itself - guarantee a generation), the higher the impact on growth. lasting impact on the growth of the recipient This condition guarantees that a maximum countries or regions. It is therefore necessary to amount of resources is directed to increase future identify the conditions under which the impact of supply, as opposed to consumption, thereby the funds can go beyond the short-term positive avoiding the risk of short-term demand pressures

demand effects and generate a positive supply and 'Dutch disease'.

response in the long run.

Second, there is a debate concerning the

Broadly speaking, there are two approaches to concentration of investment in order to achieve assessing the impact of EU funds: the effect of leverage. For some type of macroeconomic modelling and econometric investment (e.g. R&D and innovation), this may studies. Macroeconomic models (which include require concentrating most funds on a limited HERMIN used by DG REGIO, QUEST number of growth poles in a Member State rather developed by DG ECFIN and the GIMF model than spreading them across all its regions. The of the IMF) can give a rough prediction of the investment in poorer regions may concentrate in macro-economic impact of transfers and, hence, turn on improving transmission of technology are frequently used for the purposes of ex-ante and innovations from fast growing

('prospective') evaluation. Econometric models, agglomerations.

on the other hand, attempt to measure the ex-post macro-impact of EU transfers directly and are often based on various types of growth regressions. Depending on the underlying

Chapter VII

Enlargement and the EU policy framework

Box VII.5.1: Growth impact of EU support - an assessment with the QUEST model

For the period 2007 to 2013, Structural and development are modelled as reductions in fixed

Cohesion Funds (CSF) programmes for the new costs for R&D, while support to industry and

Members States amount to a total budget of 173.9 service sectors are also modelled as reductions in billion euros (in 2008 prices). Because past their fixed costs. experience has shown payments typically spread over two more years, the proposed annual Initially, GDP increases only gradually in the payment profile in terms of GDP runs up to 2015 new Member States (Graph 1) as the demand

(Table 1). The fields of intervention cover a wide effects dominate and the CSF spending crowdsrange of policy programmes. Infrastructure out some private spending due to higher inflation, investment receives the largest share of funds, an appreciating exchange rate and higher wage more than 60% of the total budget for most new growth. In the first years, GDP increases by less

Member States, while investments in human than the fiscal stimulus from the CSF spending. capital and R&D are usually the second or third But in the medium run, the positive output effects largest entries (15 and 10 % respectively). come to dominate and the increase in

productivity from more infrastructure spending, Table 1: Payment profile for new Member States, human capital investment and increase in R&D

2007-2015 intensity leads to a permanent increase in GDP of % of GDP 2007 2013 2015 as much as 4 %, even after the CSF spending has Bulgaria 1.1 2.2 1.9 come to an end.

CZ 1.2 1.9 1.7 Estonia 1.1 1.9 1.6 Graph 1: GDP effects of Cohesion Social Fund Cyprus 0.2 0.4 0.4 programmes

Latvia 1.0 2.4 2.0 5 Lithuania 1.1 2.2 1.9 % from

base li ne

Hungary 1.0 2.9 2.6

Malta 0.5 2.6 2.4 4 Poland 1.1 2.2 1.9

Ne t-transfers re ce ive d

Romania 0.7 1.5 1.3 3 (% of GDP)

Slovenia 0.6 0.9 0.8 Re al GDP

Slovakia 1.1 1.9 1.6 All NMS 1.0 2.0 1.8 2

Source: Commission services

1

For the evaluation of the potential

macroeconomic impact of the Cohesion and 0

Structural Funds on the new Member States, we 07 08 09 10 11 12 13 14 15 16 17 18 19 20

use the QUEST III model, a dynamic stochastic Source: Commission services

general equilibrium model with human capital accumulation and endogenous technological

change (Roeger et al., 2008). The productivity It should be pointed out that these simulations enhancing effect of public infrastructure is assume an efficient use of the Cohesion and modelled via an aggregate final goods production Structural Funds, which may be considered an function assuming that investment in public optimistic assumption given the potential capital increases total factor productivity with a absorption problems mentioned (Herve and certain output elasticity. The model distinguishes Holzman, 1998).

three skill groups and interventions in human

capital formation are modelled as increasing the Results are also highly sensitive to specific efficiency of each skill group on the basis of assumptions on certain model parameters, like for available estimates on the impact of the instance the output elasticity of public additional years of schooling that these infrastructure, on which there exists much interventions can finance on skill efficiencies. uncertainty in the empirical literature.

Interventions in research and technological

European Commission

Five years of an enlarged EU

Third, the investment mix matters. Spending on farm and food sector for accession. Since infrastructure as well as on training and accession, the new Member States have also education appears generally productive, even access to EU funding for the direct payments and though the returns on education are likely to take regular rural development programmes of the a considerable time to materialize On the other Common Agricultural Policy (CAP). The new hand, measures supporting cultural, sport-related Member States have moreover implemented the or social housing projects generally have little whole range of market support instruments impact on growth. Moreover, certain types of including common tariffs to third countries, interventions, such as State aid for large export subsidies, intervention purchases as well

companies, have often been found to be as production quotas for milk and sugar ( 93 ).

counterproductive or may potentially involve huge deadweight losses and should be made only A particular challenge has been to improve the in special and properly justified cases. productivity of the agricultural and food sector in the new Member States. Low productivity Fourth, the role of the macroeconomic policy is resulting from limited capital endowments and a crucial to creating a stable framework for the low use of inputs such as fertilisers, pesticides or economic development of Member States. equipment and sometimes fragmented farm Indeed, macroeconomic stability (low inflation, structures has been characteristic for agriculture an appropriate current account balance, healthy in the acceding Central and Eastern European public finances) has been found to correlate with countries. Moreover, a little productive food growth (see, for example, Ederveen et al., 2002, processing sector had to adapt to EU food quality on the importance of low inflation). Stable standards (Pouliquen, 2001; IAMO, 2004). Many macroeconomic conditions have a direct positive factors play a role in the necessary restructuring impact on economic agents by reducing the and modernisation of primary production and economic uncertainty that these agents face. food processing such as an appropriate Indirectly, they also favourably affect the volume institutional framework ensuring access to of FDI inflows, which are needed in order to capital or functioning land markets, the inflow of increase the rate of innovation and enable foreign direct investments as well as the general international spillovers. economic dynamics determining job alternatives outside agriculture and well developed social Last but not least, a favourable business security systems (Popp, 2005). The persistence environment creates conditions that are of subsistence-like farming in some new Member conducive to achieving a higher impact of the States, for example, indicates a social buffer EU Funds. Flexible product and labour markets function of agriculture in economic transition. should lead in the longer term to the disappearance of enclaves of low productivity The SAPARD programme and the rural (Boldrin and Canova, 2001). Openness also development policy have directly supported the creates favourable conditions for FDI inflows, restructuring and modernisation in the food which is one of the main channels of technology sector such as through co-financing investments transfers. Lastly, the objective of developing the in agricultural equipment and food processing. SME sector requires reducing the administrative This has contributed to increased technological burden, improving the quality of the judiciary standards, compliance with animal hygiene and system and making the legal and fiscal welfare regulations and environmental environment of enterprises less uncertain. requirements, improved employment opportunities and professional skills, new

5.3. COMMON AGRICULTURAL POLICY

With accession, the new Member States also (

93

) The ongoing CAP reform process has gradually shifted the support instruments towards direct payments to

joined the common agricultural market and farmers and increasing rural development expenditure

policy. The SAPARD programme already and has therefore reduced the share of market price

provided support between 2000 and 2006 to support in total support to EU agriculture from almost 90% in the late 1980s to around one third recently

assist the candidate countries in preparing the (OECD, 2008).

Chapter VII

Enlargement and the EU policy framework

business opportunities in rural areas and the farmers. In contrast, average real farm incomes development of information technology and in the old Member States have been more or less other infrastructure. Direct payments provide stable in recent years. Accession and the farmers moreover with stable and predictable introduction of the CAP have therefore income which may improve the conditions for contributed to increasing productivity and to investments in productivity and the access to narrowing the income gap between agriculture capital. and other economic sectors in the new Member

States. Structural change has resulted in a reduction of

583,000 (15%) full-time jobs in agriculture in the Graph VII.5.7: Real agricultural income development in selected

EU-10 between 2000 and 2007, thus in a period Member States, 2000-2007

before and after accession. These reductions 350 2000 = 100 (re al ne t valu e -adde d at factor cost pe r ful lti me ann ual work un it)

have been most pronounced in Estonia (44%),

Slovakia (39%), Lithuania (36%) and Hungary 300 C Z EE

(26%) and rather moderate in Slovenia (15%), LV the Czech Republic (13%), Latvia (13%) and 250 LT Poland (8%), compared to an average decrease in HU

agricultural employment of 13% in the old 200 PL SI

Member States. This indicates that the SK restructuring process does not run at the same 150 O MS pace as it is influenced by a number of factors and reflects different levels of competitiveness 100 and structural patterns.

50

The moderate decline in the case of the Czech 00 01 02 03 04 05 06 07

Republic can be explained by its relatively Source: Eurostat competitive structures with an average farm size of 84ha and an average labour input of 4.3 full However, regional growth may be hampered by time annual work units per 100ha, compared to an unfavourable industrial structure dominated the average of the old Member States with 21ha by agriculture that limits the role of the per farm and 4.8 work units per 100ha (all manufacturing and service sectors as drivers of figures for 2005). At the same time, the slower growth and technological innovation (Cappelen pace of restructuring in some countries tends to et al., 2003; Deller, Gould and Jones, 2003). The conserve relatively uncompetitive structures such effectiveness of regional support policies is as in the case of Poland with an average farm therefore also linked to structural change in size of only 6ha and an average labour input of agriculture, which in turn depends on economic 15 work units per 100ha. However, these growth outside the farm sector and resulting offnumbers hide a wide differentiation within farm employment opportunities. Regional Member States and the dual structure of growth and the restructuring of the agricultural commercial and subsistence-like farming. sector are hence interdependent, which should be

reflected in a coherent policy design. Income All in all, accession has triggered strong support for agriculture, for example, should also increases in farm incomes in the new Member be seen in the context of accelerating structural States with most spectacular surges in the Baltic change undertaken through regional and rural countries (Graph VII.5.7). Real incomes per fulldevelopment policies. time farmer more than tripled between 2000 and

2007 in Latvia, more than doubled in Estonia, While generally not necessarily the case, there is

Lithuania and Poland and increased by more than a danger that relatively slow restructuring of the

50% in the Czech Republic and Slovakia. This farm sector in some new Member States in growth in incomes per farmer can most likely be combination with strong income increases due to attributed to the access to the Single Market, the a considerable inflow of transfers could affect introduction of the CAP instruments as well as economic growth in rural regions, if it impeded structural change with a decreasing number of

European Commission

Five years of an enlarged EU

economic restructuring and the movement of labour from agriculture to other sectors or raised regional wages (Chaplin, Davidova and Gorten, 2004; Desmet and Ortuño Ortín, 2007). Such potential effects should be considered when analysing the distribution of direct payments in the EU. Considerable increases of direct payments as a result of a more uniform distribution of public support among farmers in the EU can help ease and accompany the transition process in agriculture, but could also increase the potential for unintended (regional) economic side effects.

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