Positive signs remain for the EU12 in spite of risks associated with a slowing Western Europe and a stronger euro.
By Dwarka Lakhan |
On the surface, the future of the enlarged European Union’s (EU) 12 newest members appears relatively bright. Their growth prospects remain buoyant compared to the rest of the EU but convergence pains; the struggle to balance growth with stability; and a sharp slowdown in developed Europe are beginning to dampen their preascension enthusiasm.
Ten of the 12 new members (EU-12) - Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia joined the EU on May 1, 2004, followed by two additional members – Romania and Bulgaria – on January 1, 2007. These countries brought EU membership to 27 and were part of the union’s largest expansion since it was first established in 1957 with six members, thereafter growing incrementally to 15 by 1995. Although the membership of the EU almost doubled, its total population increased by about only 25% and its total GDP by less than 10%.
“It is minefield out there for European investors right now. The outlook for 2008 is going to be particularly tricky as the economic landscape remains littered with potential traps and pitfalls,” states Bear Stearns in its Fourth Quarter 2007, International Market Strategist.
Average GDP growth in the 27-member EU is forecasted to fall to 2.4% in 2008, from 2.9% last year. Comparatively, GDP growth in the EU-12 is expected to be 5.4%, down from 6.25% in 2007. The stock markets of the EU-12 have also lost ground so far this year on the MSCI Frontier Markets Index. This follows strong positive growth among emerging European markets over the past three years.
In spite of weakening conditions, Mark Grammer, vice president, investments and lead manager of the Mackenzie Universal Global Future Fund expects emerging Europe to continue to grow on the back of convergence in an expanded EU. However, he cautions that the region faces the risk of a slowing Western Europe and a stronger Euro which will hurt their exports.
Chuck Bastyr, portfolio manager and chief investment officer of Toronto-based Meadowbank Asset Management contends that the EU-12 offer trade and investment opportunities, a choice of locations, improved economies of scale, reduced costs, lower taxes and increased competitiveness, which combine to make their markets attractive.
At a more macro level, the enlarged EU is expected to offer both political and economic benefits to Europe as a whole but the underlying rationale for the enlargement has been political. Barring Cyprus and Malta, all of the other new entrants were part of the former Communist Bloc which endured significant reforms in their transition to democratic free market economies following the collapse of Communism in Central and Eastern Europe in the late 1980s. As a result, for the first time since the end of the Second World War, the East/West divide has been be bridged, enhancing regional security and providing political and economic stability.
On average the new entrants have a per capita GDP that is more that 50 percent below that of the remaining 15 members (EU-15). Cyprus, the richest of the new members has a per capita GDP equivalent to 80 percent of the EU-15 average, while Slovakia, Estonia, Poland, Lithuania and Latvia each have less than 50 percent of the average. Slovenia, the second richest of the new members, has a per capita GDP comparable to the EU-15 poorest state, Greece, which is about 30% below the average.
In their run-up to membership, the new members have had to conform to broad political, economic and legal criteria that are characteristic of the established EU framework; adopt and implement EU laws; make commitments to support stable institutions and market economies able to withstand competition; and guarantee democracy, rule of law, human rights and respect for minorities.
They have also had to adhere to strict membership criteria under the EU Stability Growth Pact with respect to budget deficits, debt inflation, trade, exchange rates and interest rates. By making infrastructural adjustments to accommodate EU requirements, the new member countries accelerated their transformation process, earning greater credibility and the respect typically associated with EU membership, than if they were to pursue individual paths to change.
Ascension to the EU also led to the abolishing of import duties for manufactured goods; relaxation of capital restrictions; and the acceleration of investments in the new members by EU-15 multinationals. The EU also hastened the catch-up by providing structural and cohesion funds; access to a larger export market; and by acting as a catalyst for increased internal investment by the private sector.
In addition, lower labor costs in the EU-12 led to a shift in production from the high-cost developed Europe to Eastern and Central Europe, says Grammer. He says that production in developed Europe is generally more capital and skill-intensive versus being more labor-intensive in the new member countries. While productivity is generally lower in the new member countries, this is more than offset by savings in labor cost. This was accompanied by a transfer of technology and skills, benefiting individual companies more compared to countries as a whole.
Foreign direct investment (FDI) inflows also picked up appreciably, fuelling growth. According to the Washington, DC-based Institute of International Finance (IIF), all emerging economies are expected to receive a total of US$345 billion in net private capital flows in 2005, the highest level since 1997. Of this amount, emerging Europe is forecast to receive US$132 billion or 38% of the total. This compares to a decline in FDI in the EU between 2001 and 2004.
However, in spite of perceived benefits, the challenges of expansion have been formidable. The current expansion includes nations with diverse economic characteristics, cultures, wealth and living standards. Essentially, “Europe is seeking to unify two different worlds,” says Bastyr.
Many of the benefits of enlargement have also been the source of problems. Members of the EU-15 view shifting factories and jobs to low-wage countries in a negative light and as a source of instability, says Grammer. In addition, lower taxes and a flat-tax regime in some countries also present problems for EU-15 members who favor a flexible tax structure, he adds.
“The relocation of labor-intensive industries to the new member states is seen as increasing unemployment in the EU, particularly for unskilled workers,” Bastyr says. For this reason, the movement of labor across national borders has been restricted. Corporations are also confronted with legal and administrative barriers; no uniform recognition of academic qualifications; and social barriers resulting from linguistic, diversity and cultural differences.
The major problem in the new EU member-countries is with their governments, says Grammer. He suggests that the hangover from communism weighs heavily on their ability to adopt EU standards, resulting in questions about the depth of democracy in some of the former Communist states like Hungary, Slovakia and the Czech Republic. In addition, some countries such as Latvia and Romania are experiencing rising inflation and high current account deficits. “There is need for government reform and better fiscal management,” argues Grammer.
From an investor standpoint, Bastyr says that the stock markets of the EU-12 are relatively small, liquidity is limited and there are few quality companies of size. Therefore, market growth is largely fuelled by smaller companies which typically grow faster.
Patricia Perez-Coutts, vice president of AGF Funds Inc. in Toronto and portfolio manager of AGF Emerging Markets Fund believes that although opportunities remain in selected sectors such as banking and pharmaceutical, emerging Europe has “already enjoyed the good times” and that growth in some countries will “slow down” because of their dependence on declining trade volumes with developed Europe. “The natural catalysts in emerging Europe have been convergence and tax incentives” which are beginning to wear off, she adds. She contends that Poland, the Czech Republic and Hungary offer good investment opportunities.
Bastyr cautions that large European banks which were hurt by the credit crisis in 2007 have put a hold on many projects, limiting convergence plays and expansionary initiatives. He says “opportunities exist in areas such as real estate, banks and consumer goods, while Grammer likes the manufacturing and engineering sectors.
Mark Mobius, Singapore-based portfolio manager of the Templeton Emerging Markets Fund at Franklin Templeton Investments Inc. sees opportunities in pharmaceuticals, value-added industries, high-grade machinery and property in the region.
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| Dwarka Lakhan is the Editor of CRA Magazine. He is the President & CEO of the Caprion Group of Companies which provides integrated consulting services to the financial services industry.
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