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2 Internal Market

Integration and structural policies

This section examines, first, the extent of economic integration in the wider Europe - in both the existing EU Member States and the candidate countries - in terms of the convergence of price levels, the expansion of trade and the growth of direct investment. Secondly, it considers whether the structure of economic activity, in terms of its distribution between sectors, is becoming more or less similar between countries and regions, which reflects the extent to which these are becoming more or less specialised in the production of particular goods and services. Thirdly, it examines the possible social effects of closer integration.

Competing economic theories suggest that, on balance, closer integration should lead to a narrowing of disparities between the economies involved. However, such convergence is by no means assured and where it occurs, it could take a longer time than is socially or politically acceptable. The analysis of the previous chapter confirms that differences in income (GDP) per head both between Member States and regions appear, in fact, to have been reduced over time.
Within the global trend, there have been significant differences of experience, and while catching up has been rapid for some parts of the Union, for others, the gaps have failed to close.

Attributing cause and effect to these developments is difficult. In effect, they have coincided with, on the one hand, moves towards economic and monetary union, and, on the other hand, the introduction of cohesion policies to increase investment in the weaker parts of the Union under the Structural Funds. In Part III of this Report, the impact of the latter policies is examined in more detail.

Price differences, trade and investment flows

Narrowing price differences

As economic integration proceeds, costs of transactions between markets tend to decline so narrowing price differences. In the Union, the evidence suggests that prices across the Union are indeed becoming more similar (as shown by a recent study based on a Eurostat price survey of 270 product groups ).1 This is particularly so for manufactured goods, which are generally subject to trade, though in some cases - motor vehicles, for example - prices still differ markedly between Member States. Price differences continue to exist, however, for most services, including housing, and non-traded goods, reflecting the variation in local market conditions (See Table A.22, in Annex).

Evidence also suggests that prices of industrial goods, especially machinery and equipment, in some of the more advanced Central European countries have already become similar to those in the EU, which is perhaps to be expected given that a large part of the market is supplied by imports from the Union.

Conditions in financial markets in the EU, which were already becoming integrated during the 1990s, have become increasingly similar since the introduction of the Euro. This is particularly evident as regards nominal long-term interest rates, which reflect both expectations of future inflation rates and conditions on capital markets, which have converged to much the same level (See Graph A26, in Annex).

Cohesion country trade patterns approaching those in the more prosperous Member States

Trade between EU Member States continued to expand during the 1990s, the increase being particularly pronounced for Finland and Sweden following their accession to the EU. At the same time, there was an even stronger increase in the trade of all Member States, especially Ireland, with countries outside the Union. This reflects two factors: first, the continued process of globalisation and the further reduction of trade barriers in the context of the Uruguay round, secondly, the higher rate of growth of markets in the rest of the world, especially the US, than in the EU (See Graphs A.27 , A.28 and A.29, in Annex). The EU economies, therefore, seem to be becoming more closely integrated into the global economy at the same time as their integration with each other continues to increase.

The effects of economic Integration can also be seen in the changing pattern of trade, which tends to become more similar between countries as they become more interdependent. The evidence on trade flows indicates that the extent of intra-industry trade (which measures the similarity of the composition of exports and imports) is high for all EU Member States. This index, calculated for the EU12 (ie the euro-zone) countries' intra-EU trade from 1988 to 1998, shows that Greece, Ireland and Portugal still have a considerably lower degree of intra-industry trade than all other countries, which is suggestive of the existence of a 'development gap' regarding their productive structure. In Portugal, however, intra-industry trade has increased significantly even though the index is still lower than for all other countries except Greece. For most other countries, the index has increased, with the biggest increase having taken place for Spain, which has now a higher level than many other Member States (See Graph A.30, in annex).

CECs are not competing in the same sections of the market as EU Member States

Trade between the EU Member States and the 13 candidate countries (ie including Turkey) expanded rapidly over the 1990s, boosted in part by European agreements, and the former have become by a long way the most important trade partners of the latter. Between 1993 and 1999, the value of trade between the two groups of country multiplied by almost three times, to EUR 210 billion. The candidate countries together accounted for 13.7% of the total external exports of the Eu in 1999. The EU trade surplus with them declined significantly in 1999 but still stood at EUR 25.8 billion, 45% of it with Poland and 20% with Turkey. Both the EU share of CEC exports and the share of EU goods in CEC imports have continued to increase. The figures are highest in Hungary, where the EU share of imports was 64% in 1999, while 76% of Hungarian exports went to the EU, and in Estonia, where the figures were 65% and 73%, respectively. Growth in both these shares is also evident in the other countries, even in those, like Latvia and Lithuania, where they were relatively low.

The provisions on free trade in the European agreements with the 10 CECs have opened the way to their economic integration with the EU, and the additional agreements on agriculture, recently adopted, will advance this further. As a result, the proportion of agricultural trade exempt from duty has more than doubled from 36% to 81%, in the case of imports into the EU, and from 18% to 39%, in the case of exports to the CECs. Moreover, it has been agreed to pursue negotiations with each of the countries with a view to increasing these figures further.

In general, all countries are likely to gain from an expansion of trade, particularly those which have already established trade relations and close interdependencies in certain sectors, which tend to be those closest to the EU, on the one hand (Hungary, the Czech Republic, Poland and Slovakia), and to the CECs, on the other hand (Austria, Germany and the Nordic countries)(See Graphs A.31 and A.32, in annex)

The composition of trade between the EU and the CECs broadly conforms with expectations, given respective comparative advantages. EU exports are more concentrated than CEC exports in high-tech and advanced manufactures where labour skills are important. For most CECs, exports largely consist of relatively labour-intensive products, especially in the case of Romania, Poland and Slovakia, as well as resource-intensive ones, especially as regards the Baltic States and Bulgaria. On the other hand, the composition of exports of Slovenia, Hungary and the Czech Republic are more similar to their imports from the EU and consist to a larger extent of high-tech products (engineering goods and vehicles, especially).

Moreover, for the latter countries especially, intra-industry trade has grown relative to inter-industry trade over the 1990s. Nevertheless, a detailed analysis of the kinds of product traded within commodity groups reveals that EU exports are concentrated in higher unit value, higher quality section of the market, where labour force skills and R&D are important, whereas the CECs specialise in the lower price and lower quality end of the market, producing, for example, components which are then exported to the EU for assembly into final products. Of the CECs, only Hungary appears to be moving towards more technology- and skill-intensive engineering industries.

The conclusion seems to be that most of the CECs are not yet effectively competing in the same sections of the market with even the southern EU Member States, given the large differences in unit values between the exports of the two which exist. This suggests that the fear among the latter that enlargement could result in a large loss of their export markets is misplaced.

Trade accompanied by growing Foreign Direct Investment in the EU…

Economic integration occurs not only through trade but through foreign direct investment (FDI), by businesses setting up branches in other countries, to gain access to the market - especially important as regards services - and to take advantage of lower production costs. Provisional data from Eurostat (on FDI averaged over the years 1998 and 1999) indicate that FDI inflows are larger for Ireland, Sweden and the Benelux countries relative to GDP than for other Member States, though in the case of Ireland and the Netherlands, most of this originates from countries outside the EU. (See Graphs A.33 and A.34, in annex)

A large part of FDI takes the form of mergers and acquisitions, the number of which almost doubled between 1991 and 1999 (from 2872 to 5572, most of the increase taking place since the recovery in 1994). The number of mergers between EU companies or between companies where an EU company is a bidder has risen significantly in recent years, suggesting a move towards increased concentration of economic activity and a strong desire for companies to become larger, perhaps to be able to compete more effectively in international markets. (See Graph A.35, in annex)

With important flows into the East

EU companies are responsible for most of FDI flows into CECs, which increased significantly during the second half of the 1990s. Although the scale of flows is negligible in relation to the GDP of EU Member States, it is substantial in relation to the GDP of the recipient countries (annual flows amounting to around 5% of GDP of CECs) and is responsible for a large part of their total capital investment (around 20%). As such, FDI has had a major impact on growth and productive potential.

Much of this FDI, however, has been concentrated in three countries, Hungary, the Czech Republic and Poland, each of these accounting for 25-30% of the total (See Graph A.36, in annex). Although FDI figures are not reported at the regional level in a comparable way, selected data show that capital cities and their surrounding regions and the industrialised regions bordering the EU received a disproportionate share of investment (two-thirds of FDI to Hungary went to Budapest, 62% of the total going to Slovakia went to the Bratislava region, almost half of flows to Latvia went to Riga and the Tallinn area accounts for 80-90 % of FDI going to Estonia).2

FDI flows unlikely to affect employment and wages in the EU

According to most studies, the main motive for investing in CECs is to gain access to their markets. The fact that over half of investment is in non-traded sectors demonstrates this, but it also seems to be the case so far as investment in traded sectors is concerned. This view is also supported by the fact that most FDI takes the form of mergers and acquisitions of existing companies rather than investment in 'green field' sites (i.e. in new production facilities). Accordingly, it would seem that investment in CEC ought not to affect employment and wages in the EU greatly and that it complements, rather than replaces, exports from the EU.

The impact of integration: concentration or specialisation?

There is an ongoing debate as to whether closer economic integration, and in particular, the introduction of a single currency into a Single Market, is likely to increase or reduce the degree of regional specialisation, which is important for assessing whether or not regions are likely to become more or less vulnerable to sector-specific shocks. The evidence of the US, at least so far as manufacturing is concerned, points to specialisation increasing, 3 but it cannot necessarily be assumed that US experience will be replicated in Europe. This uncertainty is reinforced by the fact that studies so far have tended to focus on manufacturing industry, where the factors giving rise to increased concentration and agglomeration - in the form of economies of scale in production and proximity to suppliers and other producers in the same industry - are most evident. In practice, however, manufacturing is becoming less important in the Union in terms of both GDP and employment, accounting for only around a quarter of the latter, and the future location of economic activity in the EU will depend critically on the location pattern of a number of key services (the 'new economy'), which will not necessarily follow that of manufacturing.

Differing trends in regional concentration of sectors

Studies confirm that manufacturing activity in the Member States is slowly becoming more concentrated.4 The trend is not uniform, however. A number of industries that were initially spatially dispersed have become more concentrated, mainly unskilled labour-intensive ones with declining output or slow rates of growth (textiles, clothing and footwear, in particular), which have become more concentrated in southern Europe. For the regions dependent on these sectors today, there is an increased vulnerability to economic shocks similar to that which has provoked economic restructuring in the northern regions over recent decades. At the same time, around half of medium and high tech industries that were initially spatially concentrated remained so (aircraft, motor vehicles, electrical engineering, for example), while others with a highly skilled labour force and with relatively high rates of growth (office machinery, radio, TV and communications, precision instruments, for example) became more dispersed. The latter have typically spread from the central part of the Union to Ireland, Finland and southern Member States. (See Table A.23, in annex)

Analysis of the forces underlying the changes indicates that resource endowments and market potential (proximity to main markets) are of key importance. Within the former, endowment of capital, the driving force behind the location of capital intensive industries in the 1970s, seems to have lost importance in relation to the availability of an educated labour force, which has become key to determining the location of skill-intensive industries in the 1980s and 1990s. As educational attainment levels are likely to become more similar across the Union, this should be a factor working against increased spatial concentration. At the same time, market potential has become increasingly important for the location of industries with strong forward and backward linkages, central locations attracting industries higher up the value-added chain. On the other hand, the importance of market potential for industries with large potential economies of scale has declined markedly over the period.

Services an increasingly important but complicating factor

Analysis at the regional level and the inclusion of services in the picture seems to alter the conclusions, though so far the analysis conducted has incorporated only very broad service sectors so that the results need to be interpreted with caution. Not surprisingly, when a few broadly defined service sectors are included, regions appear to have become more similar in terms of the sectoral structure of their economic activity, since all regions have experienced a shift towards services. Whether this result is repeated once services are disaggregated much more and once business services, in which job creation has been especially high, are distinguished, remains to be investigated, although it is perhaps significant that the broad category of market services, together with financial services, seems at present to be relatively highly concentrated.

Nevertheless, whatever the locational forces at work, a general conclusion of the studies carried out is that the structure of economic activity tends to be slow to change, because of the scale of investment required over the long-term to alter the pattern markedly. Over the past 20-30 years, therefore, the sectoral distribution of economic activity has not changed greatly in most Member States and regions. There are, however, exceptions, such as Ireland, where growth has been more rapid and FDI much higher than elsewhere, or Finland, where the decline in GDP in the early 1990s and the subsequent restructuring of economic activity, caused in part by the collapse of the former Soviet Union, have been greater than in other parts of the Union.

The social effects of integration

While increased specialisation will tend to favour those employed in the sectors for which demand is expanding in the different economies - highly-skilled workers in the more advanced economies, low-skilled workers in the less advanced ones, where production is concentrated in low-wage, labour-intensive activities - in reality, as seen above, the outcome is unlikely to be this simple. Most trade in the EU is of an intra-industry kind, where similar goods are exchanged, and this is likely to become increasingly the case in future years.

In practice, the decline in demand for low-skilled workers, and the consequent social problems caused by their unemployment, tends to result from technological advance, which favours the more highly skilled, and highly educated, more than from trade. This implies that the problem for policy is not to seek to slow down the process of integration, but to increase the education and skill levels of workers, as well as to increase the relevance of what they are taught for the jobs for which demand is expanding.

A recent World Bank study of income distribution in 80 countries over four decades provides encouraging evidence that there is a close relationship between overall growth and the average income of the poorest 20% of the population, and that this is the case irrespective of the degree of openness to foreign trade.5 At the same time, in many countries, the relative position of the poorest in society has not improved greatly over this period, and in some it has deteriorated. Similarly, the distribution of income is more unequal in the US than in Europe and social exclusion is no less of a problem (though it seems to arise from different sources, from a withdrawal from the work force and low rates of pay more than from unemployment) despite the closer economic integration between regions.

This suggests, as in the case of regional convergence, that the policies accompanying closer economic integration, in this case social protection and active labour market policies, have an important role to play in determining the outcome. Closer integration creates a more favourable environment for a reduction in social inequalities, but it does not necessarily ensure that such a reduction is realised.

Concluding remarks

The conclusion which seems to emerge from this analysis is that the process of economic integration tends to favour a general trend towards a narrowing of disparities. Nevertheless, economic theory suggests that this is conditional on integration being complete whereas partial integration may well have adverse effects. European policies to establish economic and monetary union and the breaking down of barriers appear to have contributed positively to convergence, not least, by promoting greater macroeconomic stability, increased internal trade through lowering transaction costs in their widest sense and more competition, all of which are favourable to economic growth.6

At the same time, the impact at the level of individual regions is unpredictable, given that faster growth is inevitably accompanied by economic restructuring and given the multiplicity of factors - social and political as well as economic - that contribute to economic development. In these circumstances, it seems essential to adopt a wide-ranging approach with a number of different measures aimed at tackling the factors which determine competitiveness. This is the political conclusion on which the Member States have agreed, as reflected in successive generations of structural policies that are the subject of analysis in Part III of the report.

  1. European Commission: Market integration and differences in price levels between EU Member States; in: The EU Economy - 1999 Review, (= European Economy) Brussels/Luxembourg 1999.
  2. Cf. DIW/ EPRC: The Impact of EU Enlargement on Cohesion; draft final report of a study for the Regional Policy DG of the European Commission, Berlin and Glasgow 2000, p. 39f.
  3. See Paul R. Krugman: Lessons of Massachusetts for EMU; in: Francisco Torres/ Francesco Giavazzi (eds.): Adjustment and growth in the European Monetary Union, Cambridge 1993, pp. 241-269.
  4. Karen-Helene Midelfart-Knarvik/ Henry Overman/ Stephen Redding/ Anthony J. Venables: The Location of European Industry; Report prepared for the Economic and Financial Affairs DG of the European Commission, Economic Paper No. 142, Brussels 2000. In spite of some differences in data and methodology, many of the results have been confirmed by another study carried out for the Commission: Karl Aiginger/ Michael Böheim/ Klaus Gugler/ Michael Pfaffermayr/ Yvonne Wolfmayr-Schnitzer (WIFO): Specialisation and (Geographic) Concentration of European Manufacturing; Enterprise DG Working Paper No. 1; Background Paper for the "The Competitiveness of European Industry: 1999 Report", Brussels 1999.
  5. David Dollar / Aart Kraay 2000: Growth Is Good for the Poor; The World Bank, Development Research Group, Washington D. C., March 2000; (can be downloaded from
  6. While the high costs of accessing markets initially lead firms to be geographically dispersed and to produce for local markets, their eventual reduction makes central regions more attractive. The proximity of a large market and the realisation of economies of scale can lead to a process of agglomeration. However, full integration which results in the near elimination of transaction costs can make peripheral regions, which have maintained their low cost advantage, attractive locations for firms.



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