Latest EU expansion poses more economic problems than benefits

by Takashi Kitazume

Despite the political significance of completing the reunification of Cold War-divided Europe, this year’s enlargement of the European Union creates few near-term economic benefits and poses major challenges for the region, an expert with a British institute told a recent symposium in Tokyo.

Decades will be required for the 10 new members that joined the EU in the latest expansion in May — most of them former Soviet bloc countries — to close the income gap with their richer, older counterparts in Western Europe, said Paola Subacchi, head of the International Economics Program at the Royal Institute of International Affairs.

Subacchi was speaking at a symposium Nov. 12 at Keidanren Kaikan, organized by the Keizai Koho Center, under the theme, “Implications of the EU enlargement: is a larger EU a threat or an opportunity?”

In the biggest expansion in its 47-year-old history, the EU took in 10 new members — the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia, Cyprus and Malta, creating a huge regional bloc with a total population of 450 million.

But while their addition may have been a festive event, Subacchi noted that Europe is at a turning point: if it doesn’t reform its ways, the whole regional integration scheme could lose momentum.

The dispute over the selection of executive members for the European Commission is one clear example of Europe’s problems, she said.

“The governance problem is epitomized by the conflict between the European Parliament, which is an elected body, and the European Commission, which has a great deal of power but is not an elected body and increasingly represents the interests of national governments,” Subacchi told the audience.

“Lots of people perceive there is a lack of democracy in Europe, and that things have to be changed, and otherwise the risk is that the European Union somehow loses its legitimacy,” she said.

And there is concern in Brussels, she observed, that reforms are necessary not only in its governance, but in its economy as well.

In recent years, the European economy has not been growing fast enough, even though it has “all the right ingredients for becoming a strong economy,” Subacchi pointed out. These include a well-integrated trade area with a currency union of 12 countries at its core.

The 2004 enlargement is important to the history of Europe, she said, because it represents the end of a long process of reunification that started in 1989 with the fall of the Berlin Wall. Eight of the 10 new EU members used to be on the other side of the Iron Curtain.

“The enlargement has a large political significance, but its impact in economic terms is marginal. . . particularly on the so-called “old” EU. . . mainly because the old EU has considerably less trade with Eastern Europe than vice versa.

“So the short and medium-term economic impact is small, but the economic challenges coming from the enlargement are quite big,” she warned.

The enlargement comes at a time when expectations for strong growth in the region, especially since the creation of the euro zone in 1999, have consistently ended in disappointment, she said. Subacchi attributed this not only to a cyclical downturn, but also to structural problems in the economies of the zone’s key players — France, Germany and Italy.

On the other hand, the new EU members have been growing at an average of about 3 percent — higher than their Western counterparts.

But this does not mean their entry into the EU will have a major economic impact, because Eastern Europe accounts for only a tiny portion of Western Europe’s trade, she pointed out.

Subacchi also highlighted the small size of the East European market — the total combined population of the new member countries is less than Germany’s population alone.

“The point is that we have 10 new members which would obviously amplify the institutional or governance problems. . . but in terms of the size of the market those are not much of value,” she said.

Subacchi also pointed out that the latest enlargement has created the widest income gap ever in the union. The 10 new members are considerably poorer than the 15 older ones, with an average per capita GDP that is less than 40 percent of theirs, she noted.

This gap is much larger than the one the developed when the EU expanded southward in the 1980s with the entry of Spain, Portugal and Greece.

As of 1980, these three countries on average had per capita GDPs that were about 65 percent of those of the nine countries that belonged to the EU at that time.

And in 2003, their per capita GDP still stood at slightly above 70 percent of the nine members, she noted — evidence that injection of EU Structural Funds, aimed at compensating for the structural problems in the poorer members of the union, has not improved the situation much over the past two decades.

An estimate by the Royal Institute of International Affairs shows it would take even the more prosperous of the new members — the Czech Republic, Hungary and Poland, for example — 39 to 55 years to close the income gap with the EU average.

“The basic message is that we need two or three generations to close the income gap,” Subacchi said.

And such forecasts have strong political implications, she said, “because public opinion in Europe is increasingly turning anti-EU, and people might question, based on these numbers, ‘What are the benefits of being part of the EU if it needs such a long time to close the income gap?’ “

So what would be the role of policies to speed up the convergence process?

Especially important, she said, will be efforts to narrow the current account and budget deficits of the new member countries. This is essential because the new members are required to join the monetary union at some point, and that should happen sooner rather than later “because there is a risk of losing momentum,” she said.

As she turned to the impact of the EU’s enlargement on Asia, Su- bacchi observed that economic in tegration in Western Europe has progressed largely under government policies, whereas in Asia the process has been driven by market factors.

Today, intraregional trade accounts for 67 percent of Western Europe’s overall trade, while the corresponding figure in Asia is 48 percent. This means that Europe is more “inward-looking,” while Asia is more widely linked to the rest of the world, she said.

There are significant economic links between the EU and Asia, but they are much more important for Asia than they are for Europe. The EU is an important market for Asian exports and has become a key source of foreign direct investment over the last several years, she said.

Overall, the macroeconomic effects of the enlargement may be negative for Asia — especially for developing countries in the region — because there will be preferential treatment available for the new EU members, Subacchi said.

But such effects will be small and probably not worth worrying about, she said.

“It’s more important to develop strategies of response,” because some aspects of the enlargement can be beneficial for Asia, she added.

With a rise in labor costs in Eastern Europe and the phasing out of tax incentives for foreign investment there, some West European companies appear to be shifting labor-intensive manufacturing operations to Asia, she said.

On the other hand, Eastern European countries are moving upscale in the value chain and will have a comparative advantage there, she said. For example, a stronger European automobile industry may mean greater competition for Japanese automakers operating in the region, she said.