MESSAGE FROM THE EUROPEAN ROUND TABLE OF INDUSTRIALISTS TO THE EUROPEAN COUNCIL IN GOTHENBURG, JUNE Opening up

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1 MESSAGE FROM THE EUROPEAN ROUND TABLE OF INDUSTRIALISTS TO THE EUROPEAN COUNCIL IN GOTHENBURG, JUNE 2001 Opening up the business opportunities of EU enlargement ERT Position Paper and Analysis of the Economic Costs and Benefits of EU Enlargement This Paper was prepared by the ERT Enlargement Working Group chaired by Percy Barnevik. Research and analysis was provided by Heather Grabbe of the Centre for European Reform (CER) in London. The work was directed by Eric Vaes. The authors believe that most of these opinions are widely shared within the business community but individuals may differ on specific subjects.

2 Contents Foreword p. 4 1 EU enlargement : a balance sheet from the European Round Table of Industrialists p. 7 2 An analysis of the economic costs and benefits of EU enlargement eastwards p Introduction p. 17 Where the enlargement process stands now 2. The economic consequences of enlargement p. 21 The tangible benefits p. 22 The cost of enlarging eastwards p. 30 The opportunity costs of not enlarging p. 41 3

3 Foreword This is the second message on enlargement in little more than two years from the European Round Table of Industrialists. In 1999 we published a report entitled East-West Win-Win Business Experience, which included 16 business case studies in nine countries of Central and Eastern Europe. We are now coming back to the issue because of its paramount economic and political importance in securing one of the ERT s main objectives a stronger and more competitive Europe in the global economy. Of the crucial issues that have dominated the ERT s agenda since its formation in 1983, eastward enlargement is on a par with the creation of the single market in the 1980s and of the single currency in the 1990s. There is generally strong support for enlargement in business circles. As European citizens we see the huge importance of a united Europe in safeguarding political stability and democracy in the formerly communist countries, and peaceful development after the war-torn history of Europe. As business leaders, we focus in this new position paper on the strong and positive economic effects of enlargement in areas like growth and employment. Most ERT members have substantial investments in the applicant countries, and we have seen the positive impact of European integration on growth, trade and employment in both West and East. Most ERT Members or their local managers also participate in local Business Enlargement Councils (BECs), where we have a dialogue and action programmes with national governments to prepare for admission to the EU and to improve the investment climate. In recent years we have observed declining enthusiasm and public support for enlargement in the EU-15 Member States. Interest groups have lobbied for protection in certain sectors and to retain regional subsidies; moreover, some border countries worry about increased immigration and cross-border commuting from the East. For its part, the ERT is concerned about the slow pace of reform of the EU s own policies and governance irrespective of enlargement although some positive steps were taken recently at Nice. 4 ERT POSITION PAPER AND AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

4 In this situation, we find it important to stress the major economic advantages of enlargement, not only to the new Member States but also to the current ones. Based on economic analysis and recent research commissioned by the ERT from a UK thinktank the Centre for European Reform we have studied the consequences beyond our business observations. It is easier to estimate costs than to quantify benefits, given that we are considering a dynamic picture and looking years ahead. Yet we can go beyond models by looking at what has occurred in the last ten years in Central and Eastern Europe (CEE), and compare the experience of the accession of the southern EU Member States. Moreover, we can extrapolate from business experience to see the size of potential gains. Nevertheless, there is a tendency to be conservative in forecasting what is difficult to measure, in this case the potential economic gains. We must avoid the behaviour of the old accountant who believed that it is better to be precisely wrong than roughly right. We believe that the GDP gains of enlargement will be substantially above 10 billion for the EU-15 and some 50 billion for the applicant countries. In our view, the additional jobs could reach over 300,000 in the EU-15 and a couple of million in the applicant countries in a year time span. A significant delay in enlargement could have major negative consequences which go far beyond the lost economic opportunities. We hope that this study will contribute to a more positive attitude to eastward enlargement, and strengthen political will for rapid accessions. Percy Barnevik Chairman, Investor AB Chairman, ERT Working Group on Enlargement May

5 EU enlargement: a balance sheet from the European 1Round Table of Industrialists ERT Position Paper 7

6 EU enlargement: a balance sheet from the European Round Table of Industrialists The European Round Table of Industrialists believes that the European Union s enlargement process is losing political momentum in the face of opposition from special interests. A stronger political commitment and strategy are required. The ERT expects the EU to deliver on its promises, for the sake of both the existing Union and those countries aspiring to membership. This position paper is the second from the ERT on EU enlargement. 1 It draws on a wide range of economic studies on the subject and is based on a in-depth analysis of the tangible benefits and costs of enlarging eastwards, commissioned by the ERT from the Centre of the European Reform. The ERT trusts that this paper will help to restore political drive and commitment by demonstrating potentially huge economic and business benefits of taking applicant countries into the EU as soon as possible; putting the costs of enlargement into context. The ERT finds no justification for current anxieties that the bill for enlargement will be too high for existing Member States or for fears of large-scale emigration following the accessions; identifying six recommendations for action to give a clearer shape and purpose to the negotiations and help to bring them to a speedy conclusion for the best prepared candidates; encouraging the EU to come to grips with the institutional and policy reforms required for a successful enlargement. The economic and business benefits of enlargement Expansion of the internal market to nearly 500 million consumers offers major growth opportunities for all Member States. In addition to the gains from trade and investment already benefiting EU Member States, the accessions have the potential to boost economic growth with at least billion. The experience of Ireland, Portugal and Spain shows how accession can stimulate dynamic long-term growth in relatively poor economies. For existing Member States, the ERT study estimates a gain of around 300,000 new jobs following enlargement. 1 The first was the The East-West Win-Win Business Experience, ERT, Brussels, January

7 Gains will be driven by four factors: a strong boost to foreign direct investment (FDI) flows. For example, investment has already grown significantly and is speeding up the transformation of the economies of the ten CEE candidates. Accession will give a further stimulus to capital flows by encouraging business confidence in a predictable political and regulatory framework delivering common standards and a level playing-field across 27 (or eventually more) economies. The result will be rising training and skills standards, as well as productivity improvements, technology transfers, modernised plant and equipment, and better environment and social standards; more confidence in the political and economic futures of the new Member States. The process of legal and administrative reform leading to stable laws, regulations and standards will be better implemented, enabling businesses to make longer term decisions on strategy and investment; keener international competitiveness in both the new and the old Member States; increased cross-border trade between the new and the old Member States. The costs of delaying enlargement For the candidate countries, two potentially disastrous effects would result from delaying accession still further: political disillusionment would lead to a loss of incentive and commitment to press ahead with difficult economic and institutional reforms. Euroscepticism would grow and economic momentum weaken; much greater uncertainty about the business environment would make investment in these countries a great deal riskier, causing FDI to fall. For the EU, delay could have the effect of: weaker CEE economic growth and a real danger of higher levels of illegal migration into the EU; a decline in FDI in the candidate countries which would reduce their trade flows with the EU severely. 10 ERT POSITION PAPER

8 The dangers of enlargement are seriously exaggerated The EU is in danger of over-reacting to current anxieties that enlargement will cost too much and that it will be followed by waves of immigration from the accession countries. Having closely looked at these issues, the ERT has concluded that: The budgetary costs will be modest Planned transfers to CEE are very small. The EU has earmarked less than 10% of its total budget until 2006 for enlargement a modest outlay compared with the costs of the southern enlargement of the 1980s and only one tenth of German federal transfers to the eastern Länder after re-unification. Moreover, pre-accession spending is ring-fenced and cannot be boosted by transfers from elsewhere in the budget. The EU will itself suffer if it tries to do enlargement on the cheap. To make the enlargement of Europe a success, the EU needs to invest much more in the new Member States to improve their infrastructure and environmental standards. The EU should mobilise additional funds by making use of the European Investment Bank and public-private partnerships. The EU will be repaid many times over by the additional economic growth and business opportunities that result. Immigration into EU-15 will be a trickle, not a wave Previous enlargements involving countries well behind the economic standards of existing Member States did not result in heavy emigration. Fears of a massive movement of persons underestimate the very strong reasons why people want to stay in CEE relative political stability, economic growth and good future prospects in the countries moving towards accession. Labour mobility is relatively low within CEE at present and the Copenhagen conditions for EU-membership stable democracy, a functioning market economy and competitiveness in the single market are strong anchors to keep people in their homelands. CEE nationals currently residing in the EU amount to no more than 0.2% of the total population, although they are often thought to be more. Austria is the only country in which they number more than 1% of the national population. The most extensive study of the likely labour market impact estimates that if all ten CEE applicant countries join the Union, probably no more than 335,000 people would move into the existing Member States with free movement of labour. Only around one third of the CEE residents would be seeking employment, and the total number of additional residents would rise slowly to an equilibrium of 1% of the EU s population over the next 30 years. Daily cross-border commuting is likely to increase in frontier areas, but this will contribute to the economies of these regions. 11

9 Priorities, purpose and pressure needed: six ERT recommendations The enlargement negotiations still lack a clear framework with agreed objectives, specified timing and continuous political drive. They need priorities, purpose and pressure. The ERT recommends that the EU should: 1 > Set clearer entry requirements The candidate countries know what their desired destination is membership of the EU but most of them are struggling to establish how near or far they are from journey s end. General conditions for accession are already established, but the EU needs to clarify when the specific criteria in each area have been met by each country. For example, precisely which environmental standards are essential and which merely desirable? What should be the standards of implementation for any given regulation? The EU also needs to establish a set of benchmarks for measuring countries progress towards the Copenhagen conditions on a functioning market economy and acceptable levels of competitiveness in the Single Market. Quantitative indicators would make the criteria and the process more transparent. Clearer entry requirements would help the EU to demonstrate that its decisions on each applicant s readiness for membership are impartial and objective. They would also help maintain levels of political commitment to the negotiations in the front runner candidate countries. Finally, they would also reassure doubters that countries passed for accession are fully compliant with the entry criteria, politically stable, economically competitive and ready to play a full part in the Union. 2 > Set a date An EU commitment to a date for the first accessions would speed up preparations in the front runner candidates. CEE legislatures and administrations are finding it difficult to maintain a sense of urgency in the absence of clear evidence of an EU commitment to let them in soon. The motivating force of the goal of EU-membership will fade the longer entry is delayed. Moreover, a date for the first accessions would not bind the EU to letting in any particular country first: the best-prepared applicants should be allowed in as soon as they fulfil the criteria. 12 ERT POSITION PAPER

10 3 > Agree realistic transitional periods There are many areas in which CEE countries will not be able to meet formal EU standards on accession in full, although they have made significant progress towards them. Transitional periods will be necessary because candidate countries just do not have the funds to comply immediately but these should have a clear end date and be in areas with no impact on the Single Market. Only small amounts of aid are available for the task of meeting environmental standards, for example - which could cost up to 120 billion over 20 years for all the candidates. Any transfer of structural funds could not cover such an amount. Developing an adequate transport infrastructure could cost a further 90 billion over 10 years. Investment needs will have to be met through greater use of public-private partnerships and European Investment Bank funds, as well as transitional periods. 4 > Expand EU assistance for raising the standards of the administrative, legal and banking systems in CEE Bureaucratic inertia and over-stretched public administrations and judiciaries are major obstacles to doing business in CEE. These put a brake on overall economic development as well as on rapid integration into the EU. The Union should expand its aid and technical assistance in these areas. At the same time, the applicant countries need to accelerate their implementation of EU regulations and ensure effective implementation. 5 > Prevent development gaps from widening It is in the EU s own interest to provide more assistance to the countries whose entry is a more distant prospect. They receive little in comparison with both the less well off EU countries and the front runners for membership. Targeted funds are particularly needed to help them attract more foreign investment, which will spark a virtuous cycle of upgrading technology, industrial restructuring and higher-value exports. The EU needs to provide more funds and work with international financial institutions to ensure adequate financing for meeting development objectives in these countries, not just accession requirements. 6 > Open borders fully for business Enlargement should mean that legitimate travellers and legal goods can easily cross borders within the expanded EU. The goal of EU border policies for its new eastern frontier should be to encourage economic integration and facilitate exchange. Visa restrictions and cumbersome frontier checks inhibit cross-border trade and investment. Both the EU and the CEE countries should eliminate such barriers to market access, including bureaucratic and legal obstacles to cross-border trade and investment. 13

11 Preparing the EU: stop running away from reform The Union avoided major changes to its budget at the Berlin European Council in 1999 and to its institutions at the Nice European Council in The EU must deal decisively with its own needs and not penalise the applicant countries for its own tardiness. The ERT argues that fundamental reform of the EU is needed to create more efficient, accountable and transparent policy-making in the enlarged Union.On the policy front, the Common Agricultural Policy (CAP) and regional aid funds are in need of fundamental changes. If it is not to become a real barrier to enlargement, the CAP must be tackled before the new budgetary framework is established for 2007 onwards. Agricultural policy has to be reshaped so as to avoid long transitional periods for accession countries and disruption of markets, both within the EU and internationally. A date and no delay A precise date for enlargement is needed and none of the EU s internal reform needs should be used as an excuse for further delay. The reform and enlargement processes must progress in parallel, with neither being a brake on the other. Recent declarations by the European Council suggest that the first accessions should take place in That would be more than 15 years after the fall of communism in central and Eastern Europe and more than a decade after the EU first made a commitment to enlarge eastwards. The ERT calls on EU leaders to explain the benefits of enlargement and put the costs into context so that all of Europe can gain from the business opportunities it offers. 14 ERT POSITION PAPER

12 An analysis of the economic costs and benefits 2of EU enlargement eastwards 2 15

13 An analysis of the economic costs and benefits of EU enlargement eastwards 1 Introduction: Where the enlargement process stands now Ever since the fall of the Berlin Wall in 1989, EU enlargement has seemed five years away and it still does. But it looks like the EU will finally admit its first new postcommunist members sometime around Exactly when each individual applicant will join remains unclear. The timing depends on each country s own progress in meeting the accession conditions and the politics of enlargement among the EU-15. There are 13 formal candidates for membership: ten from Central and Eastern Europe (CEE), plus Cyprus, Malta and Turkey. All ten CEE applicants are now in negotiations, but they will finish at very different times. The five that began negotiations in 1998 (Czech Republic, Estonia, Hungary, Poland and Slovenia) are all progressing well, and the EU aims to conclude negotiations with these countries at the end of Another five countries started negotiations in February 2000: Latvia, Lithuania and Slovakia are catching up with the front runner group, but Bulgaria and Romania remain many years away from accession. Cyprus and Malta are progressing quickly in negotiations, but the opening of negotiations with Turkey remains conditional on its meeting the political criteria. The EU has set out three conditions for accession: 1 Candidate countries must have achieved stability of institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities. 2 Candidates must have a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union. 3 Candidates must be able to take on the obligations of membership including adherence to the aims of political, economic and monetary union. 2 1 Cyprus also began negotiations in 1998, and Malta in Turkey is an official candidate but is not in accession negotiations. This paper does not consider these countries progress in detail as their applications raise different questions from those of the CEE countries, but they are subject to the same accession conditions. 2 European Council (1993), Presidency Conclusions, Copenhagen. 17

14 Some of the candidate countries are progressing fast towards meeting the economic conditions, but others are unlikely to be ready for another decade or more. The European Commission s annual Regular Reports on the candidate countries show steady progress towards accession for eight of the ten East European candidates. Poland and the Czech Republic both showed good progress in 2000, winning praise for stepping up the pace of legislative alignment. Hungary is still out in front in the first group, but all five countries that started negotiations in 1998 can be considered functioning market economies. Moreover, the first five are expected to be competitive in the Single Market in the short term, provided the Czech Republic and Slovenia complete and implement remaining reforms. Latvia, Lithuania and Slovakia are catching up with the first group that started negotiations in 1998, but they are not expected to be competitive until the medium term. The Commission praised Bulgaria s efforts and progress over the past year, but its assessment of Romania s economy and administrative capacity is bleak. Neither of these last two countries is likely to join in the near future, and perhaps not for more than a decade. Malta and Cyprus are also likely to be ready for a first round of accessions, but Cypriot accession may face political obstacles owing to the division of the island. The five front runner countries have now reached the difficult issues in negotiations. In the relatively easy chapters completed so far, there remain a lot of technical issues to be resolved, but no major stumbling block has emerged. However, there are three major issues to come that could delay or even stall enlargement because of their cost and political implications: 1. Agriculture is difficult because of the potential cost of extending the Common Agricultural Policy (CAP) as it now stands to CEE farmers. Full access to the CAP for the CEE countries would be expensive because of the guaranteed prices and direct income supplements that the EU pays to farmers. Poland is the main concern, given that around one quarter of its large population lives on the land. The EU has already rejected Polish demands for transitional periods on issues like market protection, subsidies and tax reliefs for farmers, lower sanitary norms, higher milk, sugar and beef production quotas, and exceptions for particular products. However, the EU has not yet submitted a detailed negotiating position of its own. The EU position may have to await deals in WTO and EU budget negotiations, delaying the start of the critical phase of agricultural negotiations. 18 AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

15 2. Regional aid is controversial among existing Member States. Massive investment will be needed to bring CEE standards up to EU levels, many times what would be available from public finances in CEE even if taxes were raised significantly. Some investment needs are starting to be met through private-public partnerships, often with the help of international financial institutions such as the European Investment Bank. For environmental policy, the question is how to deal with the magnitude of the investment needed to meet EU waste and quality standards, even after the basic clean-up of the most polluted areas. How much of this will have to be met by public investment and how much left to private firms? Both will be needed: public investment for clean-up and waste treatment, but also businesses being forced to reduce their environmental impact by EU regulations. A balance will have to be struck between providing EU investment to assist with the costs and allowing transitional periods for coming up to EU standards (in the interim). 3. Free movement of persons. All the applicants wish to avoid blocks on the freedom of their citizens to live and work throughout the EU for many years after accession. However, some countries are asking for long transitional periods owing to domestic debates about unemployment and immigration. 19

16 When might the first CEE members join? The European Commission looks likely to be successful in completing negotiations with at least some of the front runner candidates by the end of Each Member State would then have to ratify every individual accession treaty, so the earliest entry dates still lie in Traditionally, accessions have taken place on January 1, but if the Council agrees to a mid-year date, 2004 is just possible for the first accessions. Otherwise the first new member would join on January 1, more than 15 years after the 1989 revolutions. Accession dates depend on the way Member States decide to group the applicants. It would be relatively straightforward to take in a group of the best prepared and fairly small countries. The question is whether Poland has to form part of that group. Poland will take longer because it is much larger than the other applicants (at nearly 40 million people) and has a large agricultural sector. It would be technically easiest for the EU to take in three or four of the front runners first, and leave Poland for a second round. However, this is politically difficult for Germany, which sees Poland as a priority for accession owing to its size, strategic importance and history. The issue of Poland - along with recent progress by Latvia, Lithuania and Slovakia - is encouraging discussion of a big bang approach, whereby the EU would take in eight of the CEE applicants plus Cyprus and Malta on the same day. Such a big first enlargement would take much longer for the EU to prepare. It would increase calls within the EU for another Inter-Governmental Conference (on institutional reform) before enlargement, and also a reconsideration of the budget, pushing earliest accession dates several years further away. 20 AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

17 2 The economic consequences of enlargement Enlargement will not have a dramatic and immediate effect on the EU-15 economies. All ten CEE economies put together account for less than 10% of EU GDP: such economic minnows can hardly make a major immediate impact on the Single Market. However, they already present significant business opportunities that will benefit the EU in the longer term: EU businesses will gain from the addition of nearly a third more consumers to the Single Market and the front runner CEE economies are growing somewhat faster than the current EU. The top five candidates for accession grew at an average of 3.4% over the period , in comparison with the EU s 2.4% (see Figure 1). Growth has been considerably higher in cities like Warsaw, Prague and Budapest, which offer rapidly expanding markets for west European goods. Figure 1 Average GDP Growth in the EU-15 and CEE-10 (% change on preceding year). 6 CEE-10 EU Source: European Commission (Note: 2000 is a forecast figure.) The CEE-10 by population (millions) Source: IMF World Economic Outlook (September 2000) POLAND ROMANIA CZECH REPUBLIC HUNGARY BULGARIA SLOVAKIA LITHUANIA LATVIA SLOVENIA ESTONIA 21

18 The Centre for European Reform s analysis addresses three major questions about the economics of enlargement: 1 What are the tangible benefits of enlargement? 2 How much will it cost the EU? 3 What is the opportunity cost of not enlarging or delaying accession significantly? The tangible benefits There will clearly be gains for the EU economy from enlarging its internal market to nearly half a billion consumers and bringing new growth poles into the European economy. The history of European integration shows that adopting common standards and rules opens up opportunities for economic take-off. Businesses develop greater confidence for investing in countries where economic reform is underpinned by EU-membership requirements. This investment in turn stimulates greater trade, and the resulting economic integration means business can treat European markets like one country. Accession will provide a further stimulus to capital inflows. Membership will mean greater certainty for businesses to make decisions on strategy and long-term investments, because the EU will ensure common standards and a level playing-field across 27 or even 30 economies. A common regulatory environment and open borders for trade across such a huge market offers enormous advantages to business. Take the example of previous enlargements: Spain moved into strong investment-led growth after accession, and Poland could do even better, given its faster liberalisation and integration into global markets. We already try to operate across Europe as one market, which has great advantages in allocating production to different plants in Europe. EU accession has had a direct impact on FDI inflows in previous enlargements, providing a historical case for benefits to CEE from joining. Six countries joined the EU between 1973 and 1986, and entry to the EU generally brought an increase in capital inflows. The economies that were furthest behind the existing EU Ireland, Greece, Portugal and Spain did best in stock-market performance, FDI inflows and investment-to-gdp ratios (although Greece is an exception, having performed poorly in comparison with the others). 3 ABB POLAND 3 Baldwin, Richard, Francois, Joseph, and Portes, Richard (1997), The Costs and Benefits of Eastern Enlargement: The Impact on the EU and Central Europe, Economic Policy 24 (April): AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

19 Our company is unifying trading terms all over Europe. Any difference between EU and Bulgarian regulations on circulation of goods between countries is problematic. UNILEVER BULGARIA Ireland also experienced an investment boom in the decade after its accession in 1973 and continued very impressive inflows once the Single Market was established. Portugal s investment 00rate showed a marked upswing around the beginning of accession negotiations in 1978 and it also benefited from the Single Market after Spain s inward investment rate picked up once membership had been virtually assured, although as a larger economy the FDI-to- GDP ratio is less pronounced. Ireland received FDI equivalent to nearly 10% of its GDP as the Single Market was completed in , while Portugal and Spain raised their investment rates considerably in the decade after accession. There are knock-on effects of widening the Single Market as well: greater integration raises industrial standards as EU regulations are applied across Europe. This will raise environmental standards, training and education, productivity and worker protection. Foreign investors tend to bring better environmental standards and employment practices to CEE because they already have systems in place to meet these higher standards in We provide the major attraction of jobs their home markets. 4 They are used to managing staff and with western-style employment conditions. wider corporate responsibilities (including social and environmental impact) in the competitive markets of Western Europe. GKN PLC, POLAND It is true that low costs are one driver of FDI, and there are certainly some investors who move into CEE to take advantage of lower process standards before accession. But at least as important as costs are the growing markets. The Slovak Enlargement Business Council highlights enforcement of the law as a key improvement to be made in the business environment in EU accession will keep the Commission s keenly observant eye on legal and police reform in CEE, as well as on consistency in application of EU regulations and standards. Macroeconomic and political stability are also important determinants of FDI, as are good governance and lack of corruption - all of which are positively influenced by the EU accession process. A key issue in continuing integration will be ensuring the applicants ability to implement and enforce EU legal and regulatory frameworks, and accession will ensure attention to them. Estimating the aggregate gains. Economic integration typically causes gains in GDP owing to trade creation, economies of scale and increased competition, as was the case with the completion of the Single Market in The CEE economies are currently small, so they will not have a dramatic effect on aggregate economic performance of the EU immediately: an influential study by the Centre for Economic Policy Research projected in 1997 that the incumbent EU-15 would gain about 10 billion in real income even in a conservative scenario. 5 4 Evidence from Estrin, Saul, Hughes, Kirsty, and Todd, Sarah (1997), Foreign Direct Investment in Central and Eastern Europe: Multinationals in Transition, London: RIIA/Cassell. 5 Baldwin, Francois and Portes (1997) The Costs and Benefits of Eastern Enlargement. This analysis used a calibrated general equilibrium model to simulate policy changes (such as eliminating tariffs on EU-CEE trade and access to the Single Market), in order to quantify aggregate real income and trade effects under conservative and less conservative scenarios. The gains are in

20 The consequences in a dynamic scenario over years could be significantly larger. The marginal impact of increased exports from the EU-15 could be large as CEE economies gather momentum. Both sides will gain greater competitive advantage, raising exports to markets outside Europe. The investment climate in the 13 applicant countries will lead to a substantial increase in FDI; for example, FDI in Poland has already risen from under $1 billion for the decade to $7.5 billion in 1999 alone. Poland could make gains similar to those achieved by Spain once its membership had been assured. Increased FDI also provides significant return to the EU-15 countries. Over years, these gains will dwarf the immediate impact of accession by reducing risk and lowering the transaction costs of cross-border business. For the CEE countries, there will be much greater aggregate gains in the longer term. These economies are starting from low GDP bases and will experience dynamic effects that are much larger than the one-off gains because economic integration will raise output and growth rates by stimulation of entrepreneurship, reduced risk premiums, increased investment and technology generation. 6 The CEPR study projects gains to CEE of 23 billion, even without any financial transfers from the EU, and of 50 billion if membership has a major impact on country risk perceptions (which looks increasingly likely). 7 The potential of the CEE economies is much greater than their current size. Since 1989, the CEE economies have rapidly integrated with west European and world markets, re-orienting their trade towards western markets and attracting FDI from them. They liberalised trade rapidly in fact, it was the EU that was slow to allow full access for their products (especially agricultural ones) by maintaining non-tariff barriers and safeguards. High standards in technical education are one of Slovakia s most valuable assets. They support the global competitiveness of our company. SIEMENS SLOVAKIA The process of economic integration is driven principally by investment and trade. Both are critically affected by enlargement, and they are investigated in this section of the ERT position paper. 6 This argument is made in detail in Dyker, David (2000), The Dynamic Impact on the Central-East European Economies of Accession to the European Union, One Europe or Several? Working Paper 06/00, Brighton: University of Sussex. 7 These projections are real income changes from the authors base case in 1992 ECU, not utility-based welfare changes: see Baldwin, Francois and Portes (1997) The Costs and Benefits of Eastern Enlargement. 24 AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

21 Foreign direct investment: virtuous and vicious cycles One of the key benefits of enlargement is the boost it gives to foreign direct investment (FDI). FDI inflows to CEE have increased sharply since 1994, when the EU committed itself to enlarging. This was no coincidence: recent research at London Business School suggests that the EU s commitment was a key factor in boosting FDI to the front runners. The rise in FDI after the EU s 1994 commitment to enlarge was greater than would have been justified by other factors, such as unit labour costs and market size. 8 FDI inflows have been concentrated in the countries closest to joining the EU: Polish FDI stocks have overtaken Portugal and Finland, and Hungarian stocks are approaching these levels, but Bulgaria and Romania (the furthest from accession) lag well behind. Poland and the Czech Republic have become the region s two main destinations for inflows of foreign direct investment, together accounting for 55% of all flows to the CEE in These two countries together with Hungary and Slovakia have received nearly two thirds of cumulative FDI inflows to the region in each year since 1991, with only a slight downward trend recently. By contrast, Bulgaria and Romania have received less than 10% of the CEE total during post-communist transition (see Figure 2). Figure 2 FDI flows per capita to the CEE-10, as a % of total inflows to the region (1999) BULGARIA CZECH REPUBLIC ESTONIA HUNGARY LATVIA LITHUANIA POLAND ROMANIA SLOVAKIA SLOVENIA Source: United Nations (2000) World Investment Report. FDI inflows have been concentrated in the countries closest to joining the EU. Inflows of FDI to the CEE region remain relatively small in a global context. By 1999 they reached $21.4 billion, which is just under 3% of the global total and about 10% of all FDI to developing countries. However, these relatively small values mask the importance of FDI for transition economies. FDI enables CEE economies to raise investment levels above those of domestic savings, which accelerates growth and development. The importance of foreign capital is clear from the proportion it represents of total gross fixed capital formation. 8 Bevan, Alan and Estrin, Saul (2000), The determinants of foreign direct investment in transition economies, Centre for New and Emerging Markets Discussion Paper 9, London: London Business School. 25

22 For developed economies, FDI typically comprises 4-7% of total investment; but in the case of CEE, it accounts for 7-11% (see Figure 3). So FDI adds to local savings, allowing higher rates of investment than would otherwise be possible. Figure 3 FDI inflows as a percentage of total investment Source: United Nations (2000) World Investment Report. FDI contributes much more to total investment in most of the CEE-10 than in the EU. ESTONIA BULGARIA LITHUANIA LATVIA ROMANIA HUNGARY CZECH REPUBLIC POLAND SLOVAKIA SLOVENIA CEE EU15 WORLD The benefits of our investment are not only improving the state of water infrastructure and services to customers, but also training of employees, technical exchanges, know-how, and protection of the environment to European standards. SUEZ LYONNAISE DES EAUX, CZECH REPUBLIC FDI has further benefits for transition economies. Typically, FDI brings with it technology transfer, managerial and other skills (such as marketing and distribution, which are often lacking in the early years of post-communist transition), access to markets, training for staff, and lower environmental impact. 9 Moreover, these numbers probably underestimate the impact of FDI in CEE, because foreign direct investors are actively involved in one of the most important aspects of the transition process - the restructuring of firms. Indeed, there is evidence that foreign direct investors in the transition economies are more effective than domestic owners in improving the performance of firms after privatisation. 10 EU accession prospects are a key factor influencing FDI decisions. Positive announcements of progress in accession have boosted inflows of FDI to those countries most likely to join the EU soon. Indications of when countries might join the EU have induced a bifurcation between FDI receipts to the front runners and backmarkers among the applicants. This process appears likely to be self-reinforcing, inducing virtuous cycles for the front runners 09 See Estrin, Hughes and Todd (1997), Multinationals in Transition. 10 See Meyer, Klaus (1998), Direct investment in economies in transition, Cheltenham: Edward Elgar; Frydman, Roman, Gray, Cheryl W., and Rapaczynski, Andrzej, eds. (1996), Corporate Governance in Central Europe and Russia: Banks, Funds and Foreign Investors, Vol. I., Budapest, London and New York: Central European University Press. 26 AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

23 and potentially trapping the backmarkers at a low level of economic development. FDI receipts and economic reform more generally may be further deterred if announcements of delayed accession lead to a loss of popular support for reform in the applicant countries. The effects of this bifurcation in FDI receipts are far-reaching, potentially affecting the long-term performance of CEE economies. More FDI propagates a virtuous cycle for the front runner countries as increased investment levels improve economic performance, raise country credit ratings and hence stimulate further FDI inflows. By contrast, Bulgaria and Romania both of which are likely to be excluded from the EU for many years have received lower levels of FDI, in turn further limiting their accession prospects. It is in the EU s own interest to develop parallel policies to deal with the potentially destabilising impact of the widening gap between the candidates, by providing more aid to those furthest from joining. The EU s own credibility would be damaged if it glossed over the differences between the candidates performances in its assessments of their progress towards accession. But it would help the laggards if the EU gave a clearer priority to policies that will have an immediate benefit for transition, particularly those that encourage FDI inflows. It would help even more if the EU offered more financial resources and political backing to encourage and help pay for implementation of these reforms. Then the least successful countries could hope to escape the vicious cycle of slow progress towards accession, low levels of FDI and failed reforms, by using EU policies as a motivation. Trade and competitiveness Much of the trade liberalisation between the EU and CEE has already occurred. Trade flows have already grown considerably following removal of tariffs and other barriers in the 1990s. Trade in industrial goods is largely liberalised, although agriculture remains heavily controlled owing to the barriers imposed by the Common Agricultural Policy. How will the CEE economies fare in the longer term? A key to their long-term competitiveness in the Single Market is whether and when the CEE economies will move up the value chain, away from labour-intensive goods and further towards the human capital-intensive products that dominate trade between existing members of the EU. Moving CEE economies up the value chain will require considerable industrial modernisation, by acquiring technology that cannot be produced domestically. Economies can then move into a virtuous circle of producing goods for EU markets that earn foreign exchange, which can be spent on more technology imports, to be used for more restructuring. Generating this virtuous cycle means moving further away from industrial production geared towards Soviet demand for heavy engineering equipment and relatively unsophisticated consumer goods. Already there seems to be a bifurcation in the structure of trade between CEE economies. 11 Hungary, the Czech Republic, Slovakia, 11 As argued in detail by Smith, Alan (2000), The return to Europe: the reintegration of Eastern Europe into the European economy, London: Macmillan. 27

24 Slovenia and Estonia and (to a lesser extent) Poland have a high and growing proportion of human capital-intensive exports directed at EU sectors, and are themselves a more attractive destination for FDI. Figure 4 Human capital-intensive goods as a proportion of exports (%) 20,9 17,3 16,6 10,2 65,4 HUNGARY POLAND 34,5 51,5 SLOVAKIA CZECH REPUBLIC LITHUANIA BULGARIA 43,3 SLOVENIA ESTONIA ROMANIA LATVIA 49,1 47,4 Source: Smith (2000), based on COMEXT database. Exports grew significantly in all CEE countries during the 1990s. But only in Hungary, the Czech Republic, Estonia, Slovakia, Slovenia and, to a lesser extent, Poland, are a significant proportion of exports accounted for by higher value, human capital-intensive or high-tech goods. Exports from Bulgaria, Romania, Latvia and Lithuania are still primarily lower value-added, labour intensive products that face increasing pressure from low-wage economies across the globe. Latvia, Lithuania, Bulgaria and Romania are still largely producing labour-intensive products and are concentrating production in areas where demand is declining or growing more slowly than are incomes in the EU. The political danger is that these CEE exports tend to displace existing EU producers, resulting in demands for protection. Moreover, these sectors also face severe competition from low-wage economies outside the EU. The backmarkers potential to restructure their economies towards the demand of EU markets is likely to continue to lag behind the front runners for EU-membership. Policies designed to attract more FDI to these countries are needed for their long-term competitiveness as well as for accession. Several CEE countries are improving their economic competitiveness by importing significant quantities of capital goods necessary to modernise their industry, infrastructure and agriculture. With the exception of Poland, the front runners for EU accession are buying capital goods from abroad most intensively, with six countries spending in excess of 10% of GDP on such goods. 28 AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT

25 One cause of concern for all the CEE countries is the increase in trade deficits with the EU since Does the size of the deficits reflect transitional adjustments (such as import of capital goods and technology), or a structural inability of CEE producers to compete in the Single Market? Certainly some temporary factors are involved, such as expansionary macroeconomic policies, real currency appreciation against EU currencies, and the high demand of transition economies for imports of capital goods to modernise industry, agriculture and infrastructure. However, there are concerns about the sustainability of these trade imbalances in the longer term. They have so far been financed by increased private lending to CEE (and hence growth in government debt) and by FDI. 12 The impact of accession Once accession actually takes place, how much difference will it make to integration? For the CEE countries, there could be significant benefits in several areas. The first is that accession would also give the CEE countries a say in EU decision-making. This issue was central to Austria, Finland and Sweden s motivations for joining the EU in Secondly, there are several blocked areas which are unlikely to see much progress before accession. Particularly important are liberalisation of trade in agricultural goods and lifting of contingent protection provisions, both of which would occur once CEE countries were full members. The third area of expected benefits is access to the Single Market, which is generally expected to give a boost to CEE exporters, as well as further stabilising economic policy. The likely effect is difficult to assess because of the need to take into account dynamic effects and scale effects. Extension of the Single Market eastwards seems likely to have a greater effect on CEE economic development than it has had on the EU, because Member States trade had already reached a steady state by the mid-1980s. The general opening of trade since 1989 has already led to major growth in exports and imports, but there are likely to be some further gains as a result of full access to the Single Market. One reason is that additional trade follows from increased investment. Several ERT members have experienced a major increase in cross-border trade after strategic investment: for example, specialisation in products and export market allocations can lead to dominance of the world market for a particular product. Similarly, supplier networks built up in the CEE countries manufacture to the standards (both quality and commercial) of a global group, so they can supply to plants not only in the EU but also the US. We are setting new standards for business ethics in Bulgaria. We work here as we work world-wide. SOLVAY SODI JSCO, BULGARIA Accession is thus likely to make a significant difference through investment: the experience of the accession of the Mediterranean members of the EU and of the CEE countries so far - is that businesses are much more willing to invest in countries when early accession looks certain. Moreover, accession will help to bolster the necessary underpinnings of 12 As argued by Smith (2000), The return to Europe. 29

26 well functioning, market-based economies by locking CEE countries into EU legal and regulatory frameworks. These are critical to overcoming problems of corruption in the CEE region and improving administrative capacity and judicial systems. The key to economic success in the longer term will be effective implementation and enforcement of regulatory frameworks; the vigilance of the European Commission and EU Member States will help to maintain the pressure for improving governance. The cost of enlarging eastwards There are three significant potential costs of enlargement: the costs for public finances, the costs of labour market disruption, and the costs of wage competition. None of these costs is likely to be significantly greater than the benefits, because the conditions for membership are being applied fairly strictly. The economic conditions themselves provide a safeguard against an economy coming into the EU before its firms can cope. Indeed, the European Commission has required high standards of implementation of its rules and regulations in CEE. Moreover, the potential upside for economic benefits vastly exceeds the likely costs. CEE countries have been engaged in economic reform over the past decade that is much quicker and more radical than any EU Member State has dared. Moreover, the projected net cost to the EU of enlargement is miniscule. The Centre for Economic Policy Research has estimated the net cost to the EU (of budgetary transfers to CEE minus benefits) to be between zero and 8 billion. Even the upper reach of this range is only 0.01% of EU-15 GDP (a thousandth), making the overall deal a bargain for the EU in comparison with the costs of the southern enlargement of the 1980s and of German re-unification after Public finances: the Community budget The impact of enlargement on the EU s public finances is a policy issue more than an economic one. Ultimately, the cost of enlargement on the public purse depends on how generous the EU decides to be. However, the range of estimates is fairly narrow. Getting EU enlargement started is unlikely to be costly to the EU s budget, despite the fact that the CEE economies are much poorer than most of the existing EU. This is because current EU members have decided to allocate a small amount of money to enlargement from EU public finances. Only 10% of the Community budget will go to CEE, and the total budget amounts to 1.27% of EU GNP. Moreover, the budget established up to the end of 2006 ring-fences expenditure on the new and existing Member States from each other. Small budget allocation. In previous enlargements the Community budget has been used to offset the costs of adaptation for new members by offering them fiscal transfers to aid specific aspects of their integration with existing Member States. Even when net contributors have joined (as with the EFTA accessions of 1995), funds were made available 30 AN ANALYSIS OF THE ECONOMIC COSTS AND BENEFITS OF EU ENLARGEMENT