Tue, Jan 04, 2005 - Page 9 News List

The challenges of EU enlargement

Enlargement of the euro area promises to spur further financial integration

By Rodrigo de Rato

YUSHA

For more than 50 years, Europeans have shared aspirations for closer economic cooperation and political ties. The accession of ten new countries to the EU earlier this year opened the latest and perhaps most dramatic chapter in this process. Expansion of the world's second-largest market offers historic opportunities for economic renewal.

But with enlargement come challenges. At a time of slow growth, lingering high unemployment and difficult fiscal situations in some countries, it is understandable that longer-standing members of the EU sometimes focus more on the potentially disruptive difficulties than the opportunities.

Those problems are real, but their solutions lie in the new vistas of the enlarged EU: More trade in goods and services, integration of markets and better allocation of capital, and the potentially disciplining effect of economic unification on economic policies.

The advantages for trade and investment -- more than 450 million people in 25 countries -- are self-evident. The addition of the faster-growing, middle-income economies of Central and Eastern Europe offers a larger, more diverse internal market with rising purchasing power and a well-educated workforce.

Adoption of the euro should foster even greater trade integration by eliminating exchange-rate risk, lowering transaction costs and promoting greater price transparency and competition. The experience of current euro-area members thus far suggests trade gains of roughly 10 percent just from the single currency.

Regrettably, one channel of greater integration has been muted: The free movement of labor. Most established member states -- fearing potential dislocations -- have chosen to protect, albeit temporarily, their labor markets. Several new members have adopted reciprocal restrictions. It is essential that all members keep these artificial barriers to a minimum.

Europe also has much to gain from ongoing financial integration with the eventual goal of a truly pan-European financial market. Greater market access, market reform and efforts at regulatory harmonization -- including those under the EU's Financial Services Action Plan -- should help advance this trend.

Foreign direct investment is the most direct channel for integration. By some accounts, FDI between the old and new members might be as much as 70 percent lower than justified by economic fundamentals.

Similarly, with bank credit to the private sector in the new members well below averages in the West, the scope for increasing lending activity is also substantial. Financial integration could catapult financial development for new member countries, including through the advent of new financial instruments and services.

Enlargement of the euro area promises to spur further financial integration. Enhanced competition and economies of scale in larger, more closely integrated financial markets should narrow lending margins, lower intermediation costs and allocate funds more efficiently. Greater diversification of portfolios and deeper cross-border linkages should help risk sharing, making the region more resilient to shocks.

Ultimately, progress in both trade and financial integration rests on improved economic policies. New member states should continue pursuing macroeconomic stability and financial discipline, particularly with respect to public finances. Along with strong prudential supervision, this should help manage the vulnerabilities of capital-account volatility and credit booms, and lay the groundwork for the eventual adoption of the euro.

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