With 10 new countries joining the European Union last May, many opportunities and challenges have arisen for both the new and old member states. David Berry takes a look at the situation eight months on
The European Union (EU) made a step-change in size in May 2004 with the admittance of an additional 10 countries bringing the number of member nations up to 25. From its beginnings as essentially a free-trade area of the six founding nations in 1957, EU membership now comprises a population in excess of 400 million people with a GDP similar in size to that of the US at around U$12 trillion. The potential for further future expansion, notably to include Turkey, suggests a potential population approaching 600 million, assuming that such countries are able to institute the necessary economic and social reforms to meet entry requirements.
Even with its current configuration, the EU embraces a range of countries whose economies are at diverse stages of development and whose political and social institutions reflect the turbulence of European history. While this lack of commonality provides distinct challenges to the political and financial institutions whose task it is to achieve economic alignment, it also represents a significant opportunity for investors and corporations to benefit from the impact of a substantial supply of new, relatively cheap labour. A further prospect for investors, offered by the inclusion in portfolios of countries with a low correlation of return to the more established markets, is presented through additional diversification benefits alongside the potential incremental returns associated with economic convergence trades.
The 10, predominantly Eastern European, countries that joined the EU in May 2004, do not on the surface provide an investment theme that might immediately excite investors. Together they are the equivalent of an economy the size of Holland with a standard of living around two-thirds that of the existing member states (EU 15). This labour force, however, apart from being well educated, provide a pool of employment which operates at a cost level approximately 20% of that of the EU as a whole. Although their productivity is lower than that of the existing member states this by no means negates the cost advantages. Due to the existing restrictions in labour mobility (only the UK, Sweden and Ireland are fully open to workers from the new members) the impact of the availability of these low wage rates will be seen in an upsurge in outsourcing to Eastern-based companies from those in the West.
The competitive opportunities offered by Eastern Europe are reinforced by differences in taxation rates with corporate taxes within the new joiners being significantly lower than most EU 15 countries. This disparity has already had an impact upon some of the geographically closest states with corporate tax rates being cut in Austria, Finland and Greece.
The latent opportunity offered by EU expansion is significant. The combination of large populations but relatively small GDPs suggest that such countries can experience substantial growth in domestic demand given the necessary financial reform. Well-qualified labour forces neighbouring the markets of Western Europe and the increasing integration of such countries into international trade and investment structures provide European multinational companies with tantalising opportunities.
This potential for vibrant growth contrasts sharply with the current economic sluggishness that has characterised many of the larger EU 15 economies in recent years. In Germany particularly, high labour costs and subdued domestic demand has partially offset the export-led recovery that strong growth in the US and China and Asia has supported. The pressures upon German corporates to cut costs can perhaps best be seen by reference to the World Economic Forum (WEF) competitiveness rankings in the table below.
Thus, for investors, one key aspect of EU enlargement is the potential supply-side shock that it represents and the issue is not merely how Eastern Europe may be transformed, but what will be the impact upon Western European companies and work practices.
The need for structural reform in Europe has been well understood for many years and most countries did make headway in the 1990s in terms of reforming labour markets. The case for further such measures in Germany is also largely accepted with a package of employment measures coming into force this month with the aim of increasing the flexibility of working practices. As in the UK during the 1978-79 'Winter of Discontent' such shocks can prove to be a catalyst for change which gather their own momentum and result in far-reaching structural changes.
If EU enlargement was not enough on its own to trigger such changes, its co-incident timing with the recovery in the euro and the risk that this implies to exports, suggests that corporates will be increasingly assertive in restructuring efforts.
The euro area's effective exchange rate has risen by over 20% during the last two years. Thus far, strong global demand has cushioned the area from the negative impact upon competitiveness and although euro-area companies have lost market share, export growth has still been substantial, growing by around 10% over the past year. The export picture is not consistent across the Eurozone. German exports have held up impressively, suggesting that exporting companies are already benefiting from cost cutting efforts and also reflecting particularly high levels of demand for Germany's hi-tech goods. France and Italy, however, have seen their share of the euro region's exports suffer due to a slower pace of cost reduction and, in the case of Italy, greater competition from China for its relatively low-tech exports such as white goods. Italy's traditional business model, being characterised by many small and medium-sized companies producing goods that can be made more cheaply in Asia, and potentially outsourced to Europe's emerging economies, suggests that ultimately some significant restructuring of the Italian corporate sector will be required.
In 2004, global growth reached a 28-year high but is likely to slow in 2005 and the pressure to cut production costs within the euro area will intensify. With exports amounting to approximately 38% of GDP (and the three sectors of autos, machinery and chemicals accounting for around half of this), Germany remains vulnerable to the combination of slowing global demand and the competitive threat posed by the rising euro. Ongoing attempts by companies to reduce costs through restructuring and the relocation of manufacturing facilities have impacted employment growth and this is reflected in subdued consumer demand. It can also be seen in the declining share of turnover generated domestically by the industrial stocks represented in the Dax index. Research by Deutsche Bank suggests that only five of 24 industrial stocks in the Dax still generate more than 50% of turnover in Germany. Their research indicates that the decline in the domestic share of turnover has been particularly notable for BASF (21% of turnover in Germany in 2003 compared to 44% in 1998 and RWE (50% of 2003 turnover coming from Germany compared to 75% in 1998.)
Given the undoubted pressures that the corporate sector faces, it is likely that employers will seek to transfer much of the adjustment process to the work force. Signs of such efforts are increasing - Siemens employees have recently accepted a deal which increases their working week from 35 to 40 hours with no increase in pay - an agreement which was struck in order to avoid production being transferred to Hungary. Both VW and Daimler-Chrysler have also made agreements which encompass either a wage freeze or other cost reduction measures. Further evidence of restructuring efforts within the auto industry can be seen from the tyre manufacturer Continental, where a clear strategy to increase the proportion of manufacturing carried out within low-labour cost countries has significantly benefited the share price.
During the coming year investors are likely to continue to seek out investment themes which are linked to the need to adapt to the competitive demands presented by globalisation and an expanded supply of low-wage labour. While progress in this direction will not be smooth, the benefits accruing to companies which successfully make such transition should be substantial.
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