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Central Europe's challenge to the EU

by Ben Robinson

Central Europe's challenge to the EU

The economies of central and eastern Europe, led by Poland, have been forging ahead. This is in contrast with many western and southern European countries which continue to struggle with low growth, unemployment and the financial constraints of the single currency.

The key concerns raised by participants at the National Bank of Poland’s annual conference in October focused on two main points. These were avoiding shocks to central European economies emanating from the European core and liberalising the single market to overcome barriers to intra-European Union services provision, in which central and eastern European economies have a comparative advantage.

The UK has championed both issues within the EU, making it an important partner for reform-minded central and eastern European economies. Following the UK’s Brexit, Poland and others will have to clamour for stronger competitiveness, simplified regulations and increased integration of European markets. If successful, the results could improve the prospects for the European economy as a whole, though substantial challenges exist.

Mateusz Morawiecki, Poland’s deputy prime minister, stated, ‘Three of the EU’s four freedoms – goods, capital and labour – work well, but the freedom of services is essentially non-existent.’ The main hindrance is non-tariff barriers. These include varying regulations, insurance requirements and standards across European countries, as well as differing rules on qualifications and industry association membership. This makes expanding the presence of local companies into western Europe prohibitively difficult and expensive, reducing the ability of central and eastern European firms to benefit from economies of scale and larger markets.

EU’s ‘two markets’
As a result, according to Morawiecki, the EU is ‘essentially two markets – one for central and eastern Europe and another for western Europe’. Just 14% of small and medium-sized enterprises sell their goods cross-border in the EU, while only 4% of EU services are provided cross-border, according to the European Commission. Domestic firms provide 42% of services and US firms a majority of the remainder.

Increasing the integration of central and eastern European service providers into the rest of the European economy would yield significant catch-up growth and an increase in per capita wealth. This would support higher domestic consumption and investment. The region’s strengths include transport and logistics, information technology and internet-based firms, and back office support functions. However, the relatively closed nature of western European markets to services results in substantial rents accruing to large incumbents, creating challenges to liberalising these sectors.

Digital single market benefits
Improving access to western European markets for central and eastern European services and technology companies could bring benefits to a broader EU economy suffering from sluggish growth and low productivity improvements. Full implementation of the ‘digital single market’, which aims to improve business conditions for internet-enabled firms, could raise EU growth by €415bn a year according to the European Commission.

According to the World Bank, liberalising services trade by reducing non-tariff barriers could increase productivity within the EU by 5%. Part of this boost would come from the greater competition that western European firms would face, forcing them to ensure productive use of capital and human resources.

Although the potential gains are substantial, the UK’s longstanding attempts to push services reform in the EU suggests that achieving these gains will be difficult for central and eastern European economies. EU trade liberalisation suffered a setback after a free trade deal with Canada was blocked in October, before being salvaged at the last minute.

If the EU cannot achieve internal liberalisation, it is unsurprising that external deals, including the EU-US Transatlantic Trade and Investment Partnership, are prone to difficulties. This bodes ill for UK attempts to maintain access to the single market, particularly for financial services, once it leaves the EU probably in 2019.

While non-tariff barriers account for some of the challenges that central and eastern European companies face, deeper issues over the ability to raise capital to support small and medium-sized enterprises and start-ups are also limiting progress.

Poland is vulnerable to changes in foreign capital flows, on which it depends for a large part of its domestic investment. It has a negative net international investment position of around 70% of GDP and runs a current account deficit, though this has narrowed from 5% of GDP in 2011 to a projected 0.1% this year.

The impact of bank regulations
At the same time, stricter bank regulations requiring higher capital ratios have had some impact on lending and growth rates, affecting the ability to raise debt. The extent to which this has led to limited access to bank financing is contested. Benjamin Weigert, director general of financial stability at the Deutsche Bundesbank, has highlighted the role of higher bank capitalisation in increasing resilience and mitigating shocks, thereby improving the stability of bank lending.

Implementing the capital markets union is one potential improvement, but it is not a cure-all. The more significant challenge for European fundraising is improving local firms’ access to venture capital and private equity, which could boost non-listed companies’ access to funding.

While this is a problem for Europe in general, central and eastern Europe is particularly affected. EU non-tariff barriers limiting the access of services-related SMEs and start-ups to western European markets also deter venture capital and private debt funds on account of the limited scalability of central and eastern European companies.

As political dynamics begin to shift in the run-up to the UK’s EU departure, Poland and other central and eastern European economies could play a greater role. Their support for liberalisation, particularly of services, carries significant potential. But the impact on productivity, economic growth and intra-EU convergence will depend primarily on the political will of western European nations. The evidence so far suggests it will be a long battle.

Ben Robinson is Economist at OMFIF.