Eastward Enlargement of the European Union

Despite economic glitches and political uncertainties, the European Union's eastward enlargement project is moving forward, creating important growth opportunities for both Eastern European companies and Western firms active in the region.

GROWTH TRAJECTORY OF THE EU-8

In 2004-2005, the new East European member states enjoyed a temporal output boost stemming from accession-related inventory build-ups. As those inventories unwind, the EU-8 are settling into a robust growth path that augurs favourably for the region's long-term economic prospects.

Against an EU-wide rate of 2.3%, the East European accession countries are projected to grow by 5.0% in 2006. Latvia (9%), Estonia (7.9%) and Lithuania (6.5%) lead the way, with the Central European countries posting real GDP growth rates ranging between 4.0% (Slovenia) to 6.3% (Slovak Republic).

The IMF forecasts regional growth to decline to 4.8% in 2007 - below the anticipated growth rates of China and India (9.0% and 7.0% respectively), but above those of other emerging economies (Portugal - 1.5%, Mexico - 3.1%, Spain - 3.2%, Brazil - 3.5%) and comparable to those of the advanced Asian NICs.

Expanding foreign investment, increasing absorption of EU funds and deepening structural reforms provide grounds for optimism about the sustainability of the EU-8's growth trajectory.

Parallel with their strong GDP growth rates, the new accession states are exhibiting high real wage growth, approaching 10% per annum in the Baltic republics. This wage growth path will not significantly narrow the EU-8's income gap with Western Europe - under projected income convergence rates, the wealthiest of the EU-8 (Slovenia) will attain 61% of the EU average by 2020; the poorest (Latvia) will reach 33%.

However, this scenario does signal a rising standard of living and steadily increasing purchasing power that boost Eastern Europe's commercial potential.

EAST EUROPEAN LABOUR MARKETS

Labour productivity - a vital competitive asset for small East European countries vying against giant Asian emerging markets with unassailable scale and factor cost advantages - is also growing impressively in the accession countries.

Between 2000 and 2004, the Slovak Republic registered the highest average annual growth of GDP per hour worked (5.3%) of the 30-member OECD.

During the same period, Poland, the Czech Republic and Hungary posted labour productivity growth rates (4.3%, 4.4%, and 4.5% respectively) surpassing those of Greece (3.7%), Ireland (3.9%), South Korea (4.2%) and Spain (1.3%) and well exceeding those of the USA, Japan and developed West European countries.

These productivity gains have significant repercussions for Western companies surveying the East European landscape:

• The EU-8's productivity growth enhances Eastern Europe's allure as a platform for technology-intensive investment and neutralises wage increases that threaten the region's competitive position against lower-cost emerging markets.
• Increases in labour productivity help offset the competitive effects of real currency appreciation, to which the Euro-anchored accession states are vulnerable amid mounting international investor anxieties over the US dollar.
• The EU-8's productivity performance facilitates labour market integration across the European Union. The experiences of the three EU-15 countries that opened their markets to East European workers at the May 2004 accession (Ireland, Sweden and the United Kingdom) prompted four others (Finland, Greece, Portugal and Spain) to remove their restrictions in April 2006. The expansion of Eastern Europe's skilled labour pool increases pressure on Austria, Germany and other EU-15 recalcitrants, and strengthens the rationale for labour market liberalisation in West European countries facing critical worker shortages in coming decades.

EURO INTEGRATION

In May, the European Commission rejected Lithuania's bid to join the Euro zone in January 2007.

The grounds for the European Commission's denial of early entry - Lithuania is overshooting the 2.6% inflation threshold by a fraction of a decimal point - struck many observers as an unduly mechanistic application of the Maastricht criteria that the EU loosened to accommodate the fiscal excesses of powerful states like France and Germany. Rising inflation also compelled Estonia and Latvia to postpone their adoption of the common currency.

Elsewhere, the Czech and Slovak Republics hold to their declared goals of entering the Euro zone by 2009-2010 while Poland maintains its policy of avoiding a target date.

The spike in Hungary's budget deficit - which, at 8% of GDP, far overshoots the Maastricht threshold - compelled Prime Minister Ferenc Gyurancsy to announce a fiscal austerity program on June 10. But Gyurancsy's announcement did little to allay scepticism over Hungary's Euro integration prospects. Indeed, Hungary's central bank governor admitted the country would be lucky to enter the Euro zone before 2013.

This leaves Slovenia as the sole East European country slated for admission to the Euro area in 2007 - dashing expectations of a comprehensive eastward expansion of the Euro and reinforcing doubts about the prospects for broader monetary integration in the European Union.

But the variable-speed Euro integration process underway in Eastern Europe serves several important purposes:

• The transitional mechanism of ERM II (in which Estonia, Latvia, Lithuania, Slovenia and most recently the Slovak Republic are members) affords an institutional device to pursue non-inflationary growth paths amid rising fuel and commodity prices and increasing wages.
• Competitive pressure from the fast-track Euro candidates heightens monetary discipline on the Visegrad countries that have opted out of early Euro membership.
• For an international financial community skittish over emerging market assets, the process of Euro convergence differentiates the EU-8 from other emerging economies that have undergone sharp corrections in recent months (Brazil, Indonesia, Mexico, Russia and Turkey) and lowers the risk premium of portfolio investment in Eastern Europe.

FOREIGN DIRECT INVESTMENT

At less than 5% of global FDI inflows, Eastern Europe remains a minor player in foreign direct investment. In 2005 the EU-8 collectively received $32.3 billion of FDI, one-fifth the amount reaching the United Kingdom and half the amount entering France.

But the EU-8 exhibit a growing appeal to foreign investors that belies their modest FDI numbers. Poland, the Czech Republic and Hungary are challenging the major EU states as multinational investment sites, demonstrating their lower factor costs and higher productivity growth potential.

The Visegrad countries are now the leading sites for European automotive production, and have established significant footprints in machinery, pharmaceuticals, and other advanced manufacturing industries.

The Baltic countries have also emerged as attractive destinations for Western multinationals seeking manufacturing / distribution platforms to service the pan-European market.

Indeed, Estonia ranks as one of Europe's most competitive economies, reflecting rapid diffusion of information technology, technological spillover from Finland and other highly wired Nordic economies, and a business-friendly legal / regulatory environment.

At $72.4 billion, China received more than twice the amount of foreign direct investment reaching the combined EU-8 in 2005. Upwards of 70% of last year's inbound Chinese FDI went to manufacturing, augmenting the massive stock of manufacturing-related foreign investment that has accumulated in China over the past decade.

China's low factor costs, huge domestic market, and installed multinational base ensure its primacy as a global manufacturing platform.

However, the EU-8 possess important locational advantages—notably their geographic centrality in the pan-European theater and conformance with EU intellectual property rules - which along with rising labour productivity bode well for continued foreign investment in advanced manufacturing niches.

NEXT ROUND OF EASTWARD ENLARGEMENT

Recent developments have deepened concerns over the European Union's commitment to further expansion of its eastern boundary.

In May, the EU suspended pre-accession talks with Serbia, which continues to balk at the apprehension of war crimes-suspect Ratko Mladic. EU Enlargement Commissioner Olli Rehn expressed scepticism over Bulgaria and Romania's readiness for accession, scheduled for January 2007; meeting that target hinges on the two governments' aggressive movement on corruption and organised crime.

EU officials meanwhile warned the Erdogan government that its refusal to extend customs union privileges to Greek-controlled Cyprus imperils Turkey's accession prospects.

But notwithstanding vexations over future accessions, the EU is well positioned for expansion of its eastern frontier in coming years - enlarging the geographic domain of manufacturers, distributors, and investors pursuing pan-European strategies.

• Rising intra-regional investment is deepening commercial ties between the EU-8 and accession candidates in South-Eastern Europe. Hungarian-based multinationals eager to scale out of their small domestic market are particularly active in the region: particularly in telecommunications (Magyar Telecom in Macedonia and Montenegro), energy (MOL in Croatia and Romania) and banking (OTP in Bulgaria, Croatia, Romania, and Serbia). In contrast to Portugal and Spain (which entertain serious misgivings about the admission of the East-Central Europe countries), Hungary and the other Visegrad states view EU enlargement to the Balkans as a logical and inevitable extension of the regional market.
• While a postponement of Bulgaria and Romania's accession is a real possibility, the EU-15 give no sign of abandoning their commitment to those countries' eventual entry. Meanwhile, resolution of a dispute over a war crimes suspect permitted the June 12 launch of accession talks with Croatia, whose economic indicators (per capita income comparable to Slovakia's) render it a plausible candidate for admission by the end of the decade.
• Turkey represents the foremost uncertainty of the EU's enlargement project. Even in the (improbable) scenario of a dissipation of political opposition to Turkey's admission among key EU-15 states, the country is unlikely to achieve full technical compliance with accession requirements before the middle part of the next decade. But akin to the 'anticipatory adaptation' phenomenon that spurred preparatory reforms in the EU-8 during the years preceding accession, key constituencies in Turkey (e.g. the Turkish Industrialists and Businessmen's Association) are intensifying pressure on the Ankara government to adopt EU-friendly reforms.

Uncertainties over Turkey's status have constrained foreign direct investment, which reached $9.7 billion in 2005 - versus $11.0 billion in the Czech Republic, a country whose population is less than 15% than that of Turkey's. However, the de facto (if not de jure) integration of Turkey into EU's expanding south-eastern theatre promises steadily to lower investor risk and enable the country to fulfil its FDI potential.