Tue, Jan 04, 2005 page9

• The challenges of EU enlargement

  Enlargement of the euro area promises to spur further financial integration

  • By Rodrigo de Rato
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  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.

  

  YUSHA

  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.

  Indeed, before joining the monetary union, the new member countries will need to make more progress toward the convergence criteria for interest rates, inflation and public finances. Fiscal deficits in several new member countries will need to be reduced significantly. Trimming excessive social transfers and entitlements, together with proper use of EU structural funds, would help achieve this objective while also satisfying the need for public investment and infrastructure upgrades.

  Strong financial-market supervision will also be needed to contain risks stemming from credit booms, asset bubbles and financial-market volatility. On the structural front, measures to enhance wage and price flexibility would improve resiliency to asymmetric shocks and would help the new countries' cyclical fluctuations become more attuned to the rest of the EU.

  For longstanding members, enlargement presents an opportunity to prepare public finances for coming demographic challenges. Restoring the credibility of the Stability and Growth Pact should be a top priority, but the larger challenge requires greater stability for long-term public financing. A growth-friendly approach to the burdens of aging populations is required, including steps to raise the retirement age and encourage life-long training.

  Enlargement should also give fresh impetus to policies to tackle deep-seated structural impediments and reverse sagging income prospects. The Lisbon Strategy adopted in March 2000 set an ambitious course for the EU, calling for greater focus on research and development, completion of the internal market, bold education and employment objectives, and promotion of active aging, all supported by appropriate macroeconomic policies.

  But as we approach the midpoint of this ten-year strategy, Europe stands well short of its many goals. As the recent Kok report reviewing the Strategy makes clear, "The disappointing delivery is due to an overloaded agenda, poor coordination and conflicting priorities." I share this assessment.

  The Lisbon Strategy needs to be refocused. The issue is not the productivity of European workers when they are on the job, but rather the need to increase labor-force participation through policies that raise employment rates and reverse the decline in weekly work hours. More flexible labor markets and reform of entitlement programs would further allow Europe to confront the demands of greater competition without recourse to insular protections, such as those placed on labor migration.

  Evolving market access, competition and integration may present Europe with challenges and some costs. But enlargement also creates new opportunities. Improved policies will amplify these opportunities, ensuring that economic gains will benefit hundreds of millions of people throughout Europe.

  Rodrigo de Rato, a former Spanish Minister of Finance, is Managing Director of the IMF. Copyright: Project Syndicate, December 2004.
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