The Political Economy of EU Enlargement.

University Degree Business and Administrative studies

The Political Economy of EU Enlargement

Introduction

Enlargement generally is motivated by political factors and the current enlargement is no exception. Enlargement has economic effects and these can be important but are not decisive. The enlargement to the Central and Eastern European Countries (CEECs) has two principal motivations in the EU 15:

The desire to end the artificial division of Europe that existed in the Cold War, combined with a sense of historic obligation related to West’s acquiescence in that division.
Security: to expand the area where democracy, the rule of law and prosperity holds sway.

Countries on the Baltic and bordering the CEECs see particular advantages in enlargement: security and a reduction in their peripherality. Economic advantages are likely to be greatest for these countries. The UK is very supportive of enlargement not least because of its involvement in the division of Europe. France, Spain and Portugal are lukewarm over enlargement, their security is less directly involved and the economic benefits more marginal. These counties’ budgetary position is likely to deteriorate as a result of enlargement.

The process of enlargement

Put at its most basic the new members must accept the rules of the club. So enlargement does not really involve negotiation, the existing Member States must modify the institutions and policies of the EU so that it can incorporate the new Member States. The applicant states must modify their laws, administrations and judiciary, to ensure that they are able comply with and implement EC law. The negotiations are about transitional arrangements, derogations and technical details of how the rules will apply e.g. the size of agricultural quotas. It could be argued that the real negotiation takes place once a country becomes a member. Thus the UK’s budgetary problem was well known at the time entry in 1973 but it was another 11 years before it was resolved.

Enlargement takes a long time it was 12 years from the UK’s first application for membership in 1961 until entry in 1973. This was exceptional because of President De Gaulle’s refusal to allow UK membership. Greece took 5 years form 1976 to 1981, despite an adverse opinion from the Commission. Portugal and Spain applied in 1978 and 1979 and joined in 1986. Negotiations with the EFTA countries were comparatively swift, because the European Economic Area agreement meant the economic chapters of legislation were largely implemented. In addition budgetary and policy issues were not very difficult, these countries had similar income levels to the EU average, they would not receive substantial amounts of structural aid and agriculture was not very important. So they would be net contributors to the budget.

The current process of enlargement was especially difficult, because the CEECs had to undergo a process of transition, before they could join the EU. They had to move from one party political systems to democracy. This required new constitutions, the development of political parties and a civil society. The economy had to change from a planned to a market system. Prices were not related to production costs or scarcity. Competition was absent and productivity/efficiency was very low. The structure of production determined by the plan was unrelated to consumer demand or comparative advantage. In particular heavy industry was overdeveloped and services underdeveloped. International trade had been strictly controlled, access to foreign exchange was strictly controlled, and the exchange rate was arbitrary. Macroeconomic policy was via the plan and government was financed from state run economic activity and profits on international trade. There was no tax system, capital market etc. The legal system was politically controlled, with all property owned by the state, there was no system of property rights. Corruption was endemic to the system.

The EU developed a two-pronged strategy to deal with the potential accession of the CEECs. First new association agreements, called Europe Agreements, granted free trade for industrial goods (not agriculture), aid to foster the transition process and the possibility of membership. The first Europe agreements were signed in 1991.

The second part of the strategy was to put in place a system to judge if countries were ready for membership. Premature entry could cause significant problems for the EU and the entrant. For example poor implementation of internal market laws in the new Member States could undermine the effectiveness of the Single Market (Pelkmans et al, 2000). In 1993 the EU drew up criteria to decide whether a country was ready for Membership. These Copenhagen criteria were:

stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for and protection of minorities
existence of a functioning market economy, as well as the capacity to cope with competitive pressures and market forces within the EU
ability to take on the obligations of membership, including adherence to the aims of political, economic, and monetary union.

Questionnaires were sent to the countries to complete, to assess their readiness for membership, and annual assessments were published for each country assessing its progress. In 1997 Agenda 2000 was published, the second part of which consisted of reports on the applicant countries progress in Accession. The Commission recommended that accession negotiations began with five CEECs: the Czech Republic, Estonia, Hungary, Poland and Slovenia. Negotiations opened with eight CEECs but with these five fast tracked. At Laeken in December 2001 it was decided to extend this fast track to Latvia, Lithuania and the Slovak Republic. Together with Cyprus and Malta this makes 10 potential entrants scheduled to join in 2004. The first part of Agenda 2000 consisted of recommendations for the reform of EU policies in preparation for enlargement.

This enlargement also posed particular difficulties for EU institutions. The EU’s membership had expanded from 6 to 15, largely by scaling up the EEC Treaty institutional arrangements. The limit of this process had probably been reached or even exceeded with the EU 15. The number of Commissioners was probably too large for the existing portfolios and for the effective operation of a collegiate system. The balances between the small and the large states in the system, had probably tilted too far in favour of the former, as most new Member States had been small. Another 10 states entering 9 small or very small and one large meant that institutional reform was imperative. A situation could have arisen where a qualified majority in the Council could have represented less than 50% of the population of the enlarged EU. The complexity of the EU decision making process and concerns over its democratic legitimacy also led to demands for reform.

Table 1 The impact of successive enlargements of the EU

% change

Source: European Commission 2002a, 2002b

This enlargement is unique in terms of its absolute size (in terms of population) and the low income levels of the new Member States (Table 1).

The Economic effects of Enlargement

The economic benefits and costs of enlargement fall into four categories:

The economic effects associated with the elimination of barriers to trade:

Elimination of tariff and non-tariff barriers on all EU-CEE trade. Since tariffs have been eliminated, it is non-tariff barriers that are important, the recognition that ...

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Table 1 The impact of successive enlargements of the EU

% change

Source: European Commission 2002a, 2002b

This enlargement is unique in terms of its absolute size (in terms of population) and the low income levels of the new Member States (Table 1).

The Economic effects of Enlargement

The economic benefits and costs of enlargement fall into four categories:

The economic effects associated with the elimination of barriers to trade:

Elimination of tariff and non-tariff barriers on all EU-CEE trade. Since tariffs have been eliminated, it is non-tariff barriers that are important, the recognition that CEE goods and services meet EU regulations and standards. Controls on agricultural trade will also be eliminated.
CEE will adopt the EU's CET this will have a limited effect as most CEE tariffs are at EU levels anyway. Estonia had to raise tariffs when it joined the WTO, in 1999, to conform to the EU's CET!
Preferential trade arrangements are likely to be maintained because with membership, the EU's preferential trade agreements will apply. Thus CEE countries not joining, will still enjoy free trade under their Europe Agreements.
CIS especially Russia, Belorussia and the Ukraine: the EU has limited trade concessions with these countries, under its Generalised System of Preferences, under which tariff free trade is limited by quota. Russia and the Ukraine also have Partnership and Cooperation Agreements, with provision for eventual free trade. In the meantime trade is likely to be more restricted once the CEE countries are EU members. A major problem relates to substantial cross border movements of people associated, with trade and commerce. The EU’s Justice and Home Affairs policy, means that Ukrainian and Russian citizens require visas to enter the EU but not at present to enter most CEE countries. So the substantial informal trade, conducted at open air markets, will be substantially restricted if not eliminate, by tighter borders.

The economic effects of labour and capital mobility.
The budgetary costs and benefits.
The non-budgetary effects of common policies:

The single market is considered under 1.
Health and Safety requirements will impose some additional costs on the Central and Eastern Europe companies to the extent they are higher than existing regulations. There are also significant administrative requirements and costs. This can impose additional costs on potential entrants and can be a factor in competition. Thus the food industry in Central and Eastern Europe has found it difficult to compete because it finds it difficult to comply with these regulations. There are also problems with providing products of the requisite quality.
Environmental Policy: here there will be significant extra costs ranging from new water treatment systems, to the closure and replacement of nuclear power stations.
The Common Agricultural Policy: trade effects and costs of administration. Net food exporting countries will benefit from the high internal prices, this effect is becoming less significant as CAP prices are reduced. There are very high informational and monitoring costs associated with operation of the CAP, that will be incurred by new Member States.

The economic benefits and costs of CEE enlargement

Effects of enlargement on the economy

Allocation Effects

These measure the impact of economic integration on production as a result of redistributing existing resources among industries. In perfectly competitive markets:

Trade creation effect: additional trade, which is the result of the reductions in internal protection. The effect raises welfare
Trade diversion: switching of imports from external suppliers to partners. This effect reduces welfare
Non-tariff barrier cost saving: the elimination of cost increasing non-tariff trade barriers will raise economic welfare.

The creation of a customs union is a second-best situation so no general predictions can be made concerning it is welfare outcome.

In imperfectly competitive markets:

Competition: increased efficiency as a result of increased competition.
Scale effect: reduction in the average cost of production that results from the increase in the scale of production. The saving on existing production raises national welfare and the saving on additional production increases effects 1, and 3.
Product variety: the increase in the variety of products that are made available.

Accumulation Effects

These are effects of integration on the amount of resources especially the stock of capital that is available. Improvements in technology would also fall under this heading.

Capital accumulation: impact of integration on business expectations and investment decisions.
Foreign Direct Investment: impact of integration on FDI from outside the customs union.
Technology Effects: the effect of integration on technology and managerial efficiency. This could be the result of effects on profits, investment or competition.
Migration: the additional flow of labour across national boundaries, this is anticipated to be from east to west. This will benefit western countries by raising the quantity and quality of the labour force, reducing bottlenecks. It will slow growth in CEE countries.

The potential economic benefit of enlargement to the CEE is much greater than those of the EU because the expansion in their home market is much larger. Enlargement is also more likely to be economically beneficial if the economies are competitive but potentially complementary.

Impact of Enlargement on Trade

Increased EU exports to the CEECs as a result of the elimination of the remaining barriers to trade.

Increased EU imports from the CEECs as a result of the elimination of the remaining barriers to trade.

These effects will be much greater in the CEE countries than in the EU 15

The CEECs represent a relatively small market compared with the EU 15:
Except for agriculture, tariffs are low so it is the removal of NTBs that is significant.
The overall impact on EU trade will be small, there will be a larger effect on CEE trade.

Table 1 Gross Domestic Product and Population 2002

Source: European Commission 2002a, 2002b

CEE 8 = Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia

But potential significant:

Population, AC 10 19.8% of EU 15 2002.

Rapid growth of GDP, AC10 17.0 % 2000
Rapid growth of trade
Substantial EU surplus

The trade effects of enlargement will add to demand and employment. In the CEE these effects should be significant but in the EU the short term the effects will be minor but in the long term there is the potential for substantial trade.

But

Will the CEE countries be able to compete?
Will CEE growth be held back by concentration on a narrow range of low skill labour intensive industry.

Will particular industries and regions output and employment be reduced by additional imports?
Will particular countries be adversely affected?

The impact on the EU cannot be that large because of the small productive capacity of the CEE see Table 1.

The large and widening CEE current account deficit with the EU, does not indicate that the EU has a problem competing. A deficit is to be expected during transition when there will be a large capital inflows, it is large but is sustainable in the medium term. The CEE countries are, however, in surplus in services as a result of tourist income and transport services (Roemisch, 2000). What is becoming clear is that it is possible but not inevitable that CEE countries will be able to compete. The performance of these countries has become differentiated some countries particularly Hungary, Estonia the Czech and Slovak Republics and Poland have had some success in developing technology intensive industry and exports. Labour intensive industries still remain important for exports in Poland and the Baltic states. A similar picture emerges with regard to skill intensity (Landesmann and Stehrer, 2003). Production still remains concentrated in homogeneous and scale intensive industry, so further adaptation will be necessary to sustain high rates of growth (Boeri and Martins, 2003). Future growth will also be dependent upon developing indigenous enterpreneurship at the moment the density of enterprises is lower than in the EU.

The changing pattern of specialisation and differentiation also undermines the fear that that CEE exports will be concentrated on a narrow range of industries, with significant adjustment problems, which would be regionally (nationally) concentrated.

Table 2 EU 15 - Acceding Countries trade, most important commodities 2002

million ECU

Source: European Parliament (2003)

The industrial impact of enlargement is going to be muted because:

Intra-industry trade: it might be expected that since the CEE countries have very low labour costs compared with the EU they would specialise in particular labour cost sensitive sectors where the impact on EU industry would be very great. This does not seem to be the case, much trade with the CEE seems to be intra-industry with similar products being exported and imported. Thus even in textiles and clothing where low wage cost countries are at an advantage, there are still substantial EU exports. Within these broad categories there will be specialisation. This is inevitable the high cost EU cannot compete in labour intensive sectors, so European producers would have to move up market anyway, irrespective of enlargement.

Outward processing trade: the EU exports semi-finished products for labour intensive processes to the CEECs. The products are then reimported into the EU this seems to be the case with textile and clothing where EU-CEE trade is substantial in both directions. Such outward processing trade is a way of maintaining the competitiveness of EU industry (Baldone, Sdogati and Tajoli, 2003).

Econometric studies do suggest very large increases in CEE trade with CEE exports to EU increasing by 30% (Baldwin et al, 1997), 30-60% (Brenton and Gros, 1997), 50% (Lejour et al, 2001), the increase in EU exports is very much smaller 1.5-2%. The sectoral effects in the CEE of removing tariffs and the adoption of the CET vary among industries but for most industries they are relatively low, the largest effects as might be expected are in agriculture and food processing. The effects on EU countries are small (Lejour et al, 2001).

Effect of enlargement on investment

Enlargement potentially can affect the size and location of investment.

By providing new opportunities the overall level of investment in the EU could be raised. To the extent that overall investment increases the distribution of investment becomes less important.

Investment in the EU

New market opportunities in the CEE may encourage additional investment in the EU although this effect is likely to be limited because:

the elimination of tariffs on trade has meant that many of these opportunities have already been exploited.
the small size of the CEE economies means the potential is limited but this will grow over time depending upon the performance of these economies.

Some diversion of investment particularly FDI is to be expected, as the CEE becomes a low cost production location within the EU:

EU firms investing the CEE rather than in the EU 15.
Non-EU firms investing in the CEE rather than in the EU.

The effects again are likely to be limited because:

Small size of the CEE economies. As these economies grow FDI might increase but growth will be associated with a reduction in their low wages as a comparative advantage.
FDI not very closely associated with wage levels, in many areas market size is more important.

Investment in the CEE

It is likely that internal investment in the CEE countries will be encouraged because:

Greater economic and political stability with membership of the EU.
Opportunities for export to EU markets.
Potential for faster economic growth.

However the requirements to meet EU standards in health and safety and the environment will mean additional investment in these areas.

FDI

FDI plays an important role in restructuring and in improving competitiveness, both worldwide (UNCTAD, 2001) and in the CEE (Hunya, 2000). Inflows to the CEE will be encouraged as a result of the factors cited above as encouraging domestic investment.

Table 3 EU FDI in Central and Eastern Europe

ECU/€ million

Source: EP, 2003

Eastern Europe’s share of FDI has risen steeply, in 2000 these countries were receiving less than 2% of global FDI inflows but in 2001 it was 4% and in 2002*(estimate) over 5% (FT 2002). EU FDI in CEE has risen quickly in nominal terms by over 6 times 1994-2001. It still remains a small proportion of total extra EU FDI ourflows. Since most FDI is invested in developed countries, especially the USA, fears of enormous loss of jobs as FDI flows to CEE to take advantage of low labour costs seem misplaced. Nevertheless the recent increase in the share (if not the volume) of FDI may be the first signs of an accession effect on FDI in the region, which will be important in continuing its process of convergence with the EU.

The amount and effect of FDI is uneven across the CEE both in terms of the amount and its industrial distribution. EU FDI is concentrated (over 80%) in Poland, Hungary and the Czech Republic, reflecting their economic size, and the fact that they are at the forefront of the transition process. PSA Peugeot Citroën are planning to build a €700million car plant in either the Czech Republic, Hungary, Poland or the Slovak Republic (FT 2002). Care needs to be taken in interpreting FDI because it is heavily influenced by mergers and acquisitions (privatisation in the CEE). Manufacturing has been the major target for FDI, attracting around 50% of inward FDI in the CEE (a lower % in Estonia, Latvia and Luthuania) (Landesmann and Stehrer, 2003; p.64). The industrial distribution of FDI is uneven across countries but it has been high in the food, beverages and tobacco industry, electrical, optical and transport equipment. The uneven distribution of FDI across countries is associated with differentiated catchingup. FDI seems to be attracted to medium and high tech industries and so is important in upgrading.

Effect of enlargement on migration

One of the greatest fears in the EU 15 is that enlargement would be accompanied by an a large increase in inward migration from the CEE countries. This is not a new concern exactly the same problems were raised with the Iberian enlargement. Enlargement certainly does make migration easier and there are very large differences in wage levels between the CEE and the EU 15. Migration is, however, a complex process motivated by push and pull factors. The main push factor is the lack of opportunities at home, so if the process of convergence with the EU continues, then the incentive for migration will be much reduced. Although the wage differences are a pull factor high unemployment in some countries is a deterrent. Language is another problem migrants will roughly fall into two categories, those that cannot speak a foreign language in which case they will be limited to unskilled jobs, those who can speak a foreign language and who are likely to posses other skills. There has already been considerable illegal movement of workers in the former category, this migration is any case likely to be temporary. In the latter category the movement of workers will follow shortages to the benefit of the country of immigration. Indeed, migrants as a group tend to have characteristics that benefit the recipient country, they are entrepreneurial, young, and well educated/skilled. Thus migration is likely to raise the output of the country of immigration and lower that of the country of emigration, estimates suggest that migration could be one of the most significant benefits of enlargement (European Commission, 2001). Any impact of migration has been limited by transitional arrangements [find out]. The UK which because of its low unemployment and use of English is an attractive destination for migrants has decided not to limit CEE immigration after enlargement.

Measuring the economic impact of enlargement

Estimates (Baldwin et al 1997; European Commission, 2001; Lejour et al, 2001) suggest that the allocative and accumulation gains of enlargement are beneficial to all European countries but the largest relative gains are made by the CEE. This is largely a result of the relative size of the two groupings and the greater price sensitivity of CEE exports.

These estimates are called conservative because they assume that investment rises because enlargement increases the return to capital. But there is another reason to expect enlargement to raise investment and this is because it is expected to reduce the risks of investment. These risks are related to:

micro factors such as bank failures and legal/administrative problems these are likely to be reduced as a result of enlargement.
macroeconomic uncertainty such as inflation and exchange rate uncertainty will be reduced by microeconomic reforms and by membership of the EU with its obligations with regard to macroeconomic policy.

Thus membership of the EU will reduce uncertainty and encourage further investment.

Table 4 Real income effects

% change real GDP from base case

1 CEEC7 = Czech Republic, Slovakia, Poland, Hungary, Slovenia, Bulgaria and Romania

Source: Baldwin et al (1997) p.138, European Commission, 2001, p. 33, 38, Lejour et al 2001, p.25

Distribution of gains among EU Member States

Analysis for particular EU countries suggests that EU producers and workers are unlikely to be adversely affected by increasing trade with CEE. Thus the effects are predicted to be positive or negligible (Spain) (Neven, 1995). Even the adjustment costs are likely to be limited because of increasing intra-industry trade.

Another fear is that CEE competes head on with Southern Europe in terms of low labour costs. Analysis of current export specialisation does not support these fears (Dimelis & Gatsios, 1995; Gual & Martin, 1995) these indicate very different export specialisations and no tendency for convergence of specialisation during transition.

Initial analysis of factor endowments (CEPR, 1990; Hamilton & Winters, 1992) suggested that CEE was relatively well endowed with human capital and would, therefore, specialise in sophisticated products in competition with Northern Europe. More detailed analysis (Halpern, 1995; Landesmann and Sterher, 2003) contradicts this conclusion. Participation rates especially in tertiary education are low, as are indicators such as scientists and engineers in the population, R&D share of GNP and the proportion of R&D personnel in manufacturing thus CEE is not very well equipped to compete in the more advanced areas of industry. In the near future the comparative advantage of CEE seems likely to be in labour intensive production. The analyses based on revealed comparative advantage do not, however, suggest that such specialisation will have significant impacts on employment and production.

A rather crude distribution of benefits of enlargement among countries suggests that Germany is the major gainer, Ireland and Greece gain proportionately little. Portugal is a marginal net loser because of competition for its textile industry.

Table 6 Distribution of gains among EU incumbents

(change from base case, less conservative scenario)

Source: Baldwin et al (1997) p.149; Lejour et al 2001, p.25

The likely production and employment impacts of CEE integration with the EU are likely to be small and spread over a comparatively long period. This together with the intra-industry nature of most trade should ease the adjustment to new the pattern of production. There is no evidence that particular EU countries or regions are likely to be very adversely affected. This indicates that the adjustment problems of CEE enlargement are not likely to be great and all studies agree that the integration of these economies to the EU will overall have a positive impact.

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The political economy of EU enlargement