Speech

Challenges and Opportunities in the New Europe
Remarks by Rodrigo de Rato
Managing Director of the International Monetary Fund
to the Third Congress of CEDE CEOs
Valencia, Spain November 25, 2004
As prepared for delivery

Thank you very much for your invitation to participate in this, CEDE's Third Congress. I would like to speak to you today on the challenges facing the economies of the European Union. I will begin with a few words on the near-term outlook for Europe, and then focus my remarks on the opportunities that the recent EU enlargement can provide for European citizens, businesses and governments.

The global recovery remains relatively solidly established and now embraces all the world's regions. Despite a noticeable slowing in the momentum of the recovery from the second quarter of this year, partly reflecting the impact of rising oil prices, global GDP growth in 2004 is nonetheless expected to average 5 percent and exceed 4 percent in 2005. In the euro area too, growth gained some momentum in the first half of the year, but activity has softened more recently. The pickup that was to take place in the second half of 2004 is looking a lot less robust than originally envisaged. The first round of estimates for the 3^rd quarter suggest the euro area is growing at an annual rate of under 2 percent. Higher oil prices and a slower-than-expected pick up in employment pose a risk to the outlook, as does the renewed appreciation of the euro. Inflationary pressures in the euro area remain contained. Although the ECB will need to watch carefully for second round effects from higher oil prices, monetary policy should remain accommodative until a self-sustaining upturn in domestic demand is evident. The fiscal policy stance has been loosened modestly in the current downturn and should be tightened as the upturn solidifies.

Looking beyond the near-term, deep-seated problems are facing the older members of the European Union. Jobs are scarce for many and unemployment remains high. The tax burden on workers and businesses in many countries is large, yet fiscal positions are not sustainable in a number of countries. Population aging will put further pressure on already strained welfare systems.

Against this background, it is not surprising that the older members sometimes see EU enlargement in terms of the challenges it poses for them. But I think that landmark events, such as membership enlargement, can offer opportunities for economic renewal. I see opportunities in three areas: first, in more trade of goods and services; second, in the integration of financial markets and better allocation of capital; third, and perhaps most importantly, in the potentially disciplining effect of integration on economic policies.

More Trade

The addition of ten new members expands the roster of countries in the Union by two-thirds, its land area by a fourth, and its population by a fifth-it now surpasses 450 million people.

The immediate opportunity is that enlargement promises to open markets further, increase trade and investment throughout the Union, and thereby boost growth and job creation. Evidence suggests that EU enlargements over the past 20 years—with the accession of Greece in 1981, Spain and Portugal in 1986, and Austria, Finland, and Sweden in 1995—have led to trade creation among EU members that exceeded trade diversion effects by some 40 percent.

This trend should continue in an expanded union of 25 countries. With the latest enlargement, the inclusion of the faster-growing, middle-income economies offers a larger, more diverse internal market. Indeed, trade and financial flows have already seen dramatic gains in the prelude to accession. With greater market access, the increase in diversity should open up new trading opportunities among the membership where differences in comparative advantage are clearly evident. With a substantial population, rising purchasing power, and a well-educated workforce, the new membership also provides a growing, healthy source of demand and new market and investment opportunities for firms throughout the union. All in all, evidence suggests that trade between the old and the new members might presently be about 30 percent lower than justified by long-run fundamentals, indicating a large potential for gains.

Euro adoption should in time foster further trade integration, by eliminating exchange rate uncertainty, lowering transaction costs, and promoting greater price transparency and competition. The early returns based on the experience of current euro area members thus far suggest trade gains on the order of 10 percent have been created by the adoption of the single currency.

Regrettably, one channel of greater integration has been muted: the free movement of labor. Most old member states—fearing potential dislocations—have chosen to protect, albeit temporarily, their labor markets. Transitory restrictions (for as long as seven years) on labor migration from new member states will limit for now the cornerstone freedom to work anywhere in the Union. Several new member states have adopted reciprocal restrictions. I would encourage member states to hold these artificial barriers to a minimum and embrace, with both arms, each of the "four freedoms"—i.e., the free movement of capital, goods, services, and labor—that define the Internal Market.

Greater Financial Integration

Let me turn now to the second opportunity I mentioned at the outset. Europe has much to gain from on-going financial integration. Enlargement offers the possibility of even larger gains and constitutes a key step toward the eventual formation of a truly pan-European financial market. Greater market access, market reform, and regulatory harmonization efforts—including those under the EU's Financial Services Action Plan—should help foster greater financial integration in Europe. FDI is perhaps the most direct channel. Past enlargements have raised FDI among members. By some accounts, FDI between the old and new members might be as much as 70 percent lower than justified by fundamentals, indicating that, as with trade, there are huge potential gains.

With bank credit to the private sector, relative to economic activity, being well below the averages in the west, the scope for increasing lending activity is also substantial in the new membership. The prospect of financial integration thus holds the remarkable opportunity of catapulting financial development for new member states, including through the advent of new financial instruments and services.

Euro adoption in the new membership promises to spur further financial integration. For euro area members, financial integration, in many of its facets, has already made great strides, particularly in area-wide fixed income and money markets. But many studies point to substantial further gains that can be realized. Enhanced competition and scale economies in larger, more closely integrated financial markets should narrow lending margins, lower intermediation costs, and allocate funds more efficiently to spur economic growth. And greater diversification of portfolios and deeper cross-border linkages should help risk sharing, making the region more resilient to shocks.

Better Policies

This brings me to the third opportunity I mentioned, the role of policies and what they can do to help build the benefits of enlargement.

Let me start with the policies at the EU level. Regarding competition policy, in sectors where firms are unable to retool to compete effectively, the task should be to focus on facilitating resource reallocation rather than guarding vested interests. The EU is best served when the playing field is kept level and not by limiting market access through national barriers. More generally, strong monitoring and enforcement of Internal Market laws, efforts to harmonize financial regulations, and enhanced surveillance and coordination of macroeconomic policies will strengthen competition. This, in turn, should exert a disciplining effect on national policies and herein lies a major hope for a more vibrant Union.

Charting the right course for national policies depends partly on country circumstances. New member states should continue down the road toward macroeconomic stability and financial discipline, particularly with respect to public finances. Along with strong prudential supervision, this should help manage the vulnerabilities associated with capital account volatility and credit booms, and lay the necessary groundwork for ERM II entry and the eventual replacement of national currencies with the euro.

Adopting the euro, in turn, would propel a "second wave" of trade and financial integration, as indicated by preliminary returns from current euro area members' experiences. But before monetary union can be seriously considered, these countries will need to make more progress toward meeting the nominal convergence criteria for interest rates, inflation and public finances. Fiscal deficits in several of the new member countries will need to be reduced to meet euro area standards (and Maastricht limits). Trimming bloated social transfers and entitlements, and properly utilizing EU structural funds, would help achieve this objective while also satisfying the needs of public investment and upgrading of infrastructure. Alongside determined fiscal adjustment, strong financial market supervision will also be needed to contain incipient risks stemming from credit booms, asset bubbles, and financial market volatility. On the structural front, measures to further enhance wage and price flexibility would improve the resiliency of these economies to asymmetric shocks and would help their cyclical fluctuations become more in tune with the rest of the union.

For older member states, enlargement presents a new opportunity to help prepare public finances for the pressures that will emanate from population aging. Fiscal policies, particularly in the largest member states, have not broken free from their procyclical histories—behaving in good times as if the good times were here to stay. After a protracted economic slowdown, this has left a significant number of member states in breach, to varying degrees, of the Stability and Growth Pact. I think that restoring the credibility of the SGP should be a top priority, not only for existing euro area members but also to help anchor the fiscal consolidation and convergence efforts in the new membership. But the larger fiscal challenge revolves around placing longer-term public finances on a sounder footing. The challenges stemming from aging populations loom large in the EU, including in new members. Life-expectancy has risen steadily over the past decades but the length of working lives has fallen. In many countries, this has left the current generation of workers and businesses with the heavy burden of funding generous retirement schemes. Matters will only get worse as aging accelerates after 2010 in many countries, with the rising revenue burden creating a risk that output growth will almost grind to a halt. What is urgently required is a growth-friendly approach to address these challenges, including steps to raise the retirement age and encourage more life-long training.

Enlargement should also give fresh impetus to the implementation of policies needed to tackle deep-seated structural impediments and reverse sagging income prospects in the old union. Lackluster growth in recent years has been the defining economic challenge faced by Western Europe. Since the mid-1970s, following more than two decades of significant convergence, the advance in per capita incomes has essentially stalled relative to U.S. levels, owing largely to declining work effort. Some see lagging productivity as the key culprit. Indeed, the sub-par growth record, at least since the mid-1990s, does in part reflect an inability to fully harness new growth opportunities, including new technology and globalization, largely in the service sectors. A careful look at the data, though, reveals that the root cause for the stagnation of per capita incomes has been the relative secular decline in labor force participation, both in terms of employment rates and annual hours worked (per employee).

The Lisbon Strategy adopted in March 2000 set an ambitious course for the European Union "to become the most competitive ... economy in the world." Among its long list of laudable objectives, Lisbon includes promoting research and development and innovation, completing the internal market, targeting education and employment objectives, and promoting activity among the aging, all supported by an appropriate macroeconomic policies. But as we approach the half-way point (2005) of this ten-year strategy, Europe stands well short of its many targets. As the recent high-level report reviewing the Strategy, headed by Prime Minister Kok, makes clear, "the disappointing delivery is due to an overloaded agenda, poor coordination, and conflicting priorities." I share this assessment.

The World Economic Forum also made an attempt this year to assess progress, using as a yardstick the eight dimensions of competitiveness adopted in the Lisbon Strategy. Again, the findings are sobering. The United States scores better than the EU on average in seven of the eight dimensions. The average accession countries perform almost as well, and in some cases better than the worst performers among the older EU members. The Forum's report concludes that reaching the Lisbon goal will "require continued efforts to improve the competitiveness environments of the accession countries" as well as those among the older members who are lagging behind.

Lisbon's apparent delivery gap makes clear that implementation and the key objectives—particularly, improving work incentives and reversing the decline in work effort—require renewed focus. To achieve this, a re-orientation of the Strategy around a consensus on the need to raise labor force participation would be helpful. This would require policies with the leverage to raise employment rates and reverse the decline in weekly work hours. More flexible labor markets and reform of entitlement programs would further allow the old union to confront the demands of greater competition without recourse to insular protections, such as those placed on worker migration.

Conclusion

Let me conclude. For more than half a century, Europeans have shared aspirations for closer economic cooperation and political ties. The latest chapter in this endeavor—the accession of ten new countries on May 1 earlier this year—further changes the map, and increases the diversity, of the European Union. For new member states, full access to the world's second-largest Single Market offers an historic occasion to accelerate productivity catch-up and income convergence.

With the shared goals and common purpose that it represents, the process of enlargement has set in motion a renewed impulse to forge closer ties between the new and established members of the EU. Greater trade and financial integration promises to boost growth and employment for the entire region, revitalizing the economies in the west, and accelerating the convergence between the economies of the east and the west.

But with enlargement also comes the inevitable challenges that accompany change. The new configuration has set in motion agents of change, some of which could become disruptive. The challenge will be to manage the possible displacement and disruption that may accompany evolving market access, competition, and integration without choking off the opportunities and benefits that they provide. This will require better policies, at both the macroeconomic and microeconomic levels, to make the economic gains from enlargement a reality and not a promise only partly fulfilled.

Thank you.