The accession of 10 new member states to the European Union means superior future growth prospects not only for the enlarged region but for global investors too
Western European economies have experienced three years of challenging markets, where most sectors and companies have been forced to refocus and cut costs. As the economic recovery gathers pace, it will be boosted by the contribution of the 10 new members of the newly enlarged European Union (EU).
Intratrade between 'established' Europe and the 'converging' countries in the same geographic region is already significant and set to grow as the ageing populations and high fiscal deficits of western Europe are counterbalanced by the growing potential of the new EU members.
The EU has grown from just six countries (France, West Germany, Belgium, Italy and Luxembourg) in 1957 to 25 member states now. The 10 new additions on May 1 were the Czech Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. The European bloc's population is now 450 million, and its territory covers 1.5 million square miles. In comparison, the US has a population of around 290 million with a territory of 3.7 million square miles.
"Three years ago the investment story among the 'converging European' markets was higher growth prospects at very attractive valuations with some risk ahead of convergence," says James Macmillan, head of European equities at Merrill Lynch Investment Managers.
"Now, the risk factor has reduced because accession happened in an orderly fashion and valuations have largely been arbitraged away. But there are still superior future growth prospects, running at 3%-5% per year in these countries, to play for."
The overriding political aim of the expanded EU has been to bind the region's nations more closely together to avoid the economically damaging wars of the last few decades. Much work has been done to prepare the new members for accession. The EU has already spent the current dollar value equivalent of twice the cost of the US post-World War II Marshall Plan on the accession process. More structuralfunding is planned to assist new members to improve their infrastructure and administrative capacities.
While closer political integration within the EU is controversial to some members, greater economic prosperity is an aim on which they can all agree upon. The new member states have a combined gross domestic product (GDP) of less than 5% of the existing EU 15, and their GDP per capita is on average about 35% of that of the EU 15.
With enlargement, the gap in income distribution within the 25 new states will rise by about 20%, twice as much as the increase when the EU took in Greece, Spain and Portugal in the 1980s. But the greatly increased number of consumers implies growing purchasing power and opportunities for companies across the bloc.
"The increasing GDP per capita and rising living standards is what will drive growth," says Macmillan. "Latvia might not have a Tesco yet, but the Czech Republic has. There are not too many sophisticated DIY shops in the Czech Republic. but they are opening up in Poland. Advertising will also boost consumption, but products have to be relevant to consumers in each country."
For both regional and global investors, the enlarged EU extends regulatory supervision and institutional practices to new markets, reducing certain risk factors. "If you are a US company looking at expanding into Central Europe, you would wait to invest until after the state joined the EU, so there is a better legal and regulatory framework. Rights such as intellectual property would be much more firmly enforced," notes Macmillan. The attraction for expanding companies is the relatively cheap labour costs in the newly joined states, combined with a high skill level among the workforce. A fully costed worker in Germany costs $25/hour. In Poland, the wage is $2.50/hour while in second wave convergence countries such as Romania and Bulgaria, it is about $1.50/hour.
For big companies, the new European markets will be a logical base to manufacture or add value to product that is then sold on to other countries both inside and outside the EU.
Macmillan expects the wage differential to narrow as harmonisation between the older EU members and the new ones takes place. The process will also cap wages in developed countries, and contribute to greater labour mobility within the bloc. But as the experience of previous emerging European countries such as Greece, Spain and Portugal shows full integration takes time, anything from five to 10 years.
"The process is not yet complete for Greece, for example, and the GDP per capita for Spain and Portugal is still lower than for the core EU countries like France and Germany," he adds.
Each industry will face specific challenges. The subsidy-hungry agricultural sector is under particular pressure. With 25 members states there are now 11 million farms within the bloc, up from seven million when there were just the EU 15.
The number of people working in agriculture will rise from 4% of the working population before the latest round of accession, to 5.5% of the population. By comparison, there are just two million farms in the US, and just over 2% of the US workforce in this sector.
Infrastructure needs to be functioning before any commercial development can take place. The EU's structural development funds will underpin ambitious programmes to update and build roads, rail links, bridges, power networks and, importantly, IT infrastructure.
"These are 15- to 20-year programmes for which companies in western Europe will be keen to bid, possibly with local partners," says Macmillan. "That is why the stock markets in converging European countries have been doing so well recently, there are very long-term economic cycles driving investment growth."
Accession to the EU has already had a significant deflationary effect on the converging countries, much as the European exchange rate mechanism (ERM) had on the EU15 when it was introduced.
"A single European currency reduced national inflation rates, boosted bond issuance and the ability of companies in these countries to raise finance. They could get a lower borrowing rate because of the reduced risk premium."
Sectors such as banking and finance and real estate, which require a strong regulatory framework, but where skills are highly transferable, are set to flourish in converging countries. "Think of banks like Unicredito, AIB, Erste Bank and KBC, which are already present in some of these countries," says Macmillan. "The banking and finance market is very under-penetrated in terms of mortgage provision and other financial services. They are expecting a 20%-30% revenue growth rate every year over the next three to four years."
Domestic bank credit as a percentage of GDP is far below western European levels, and there is strong appetite among consumers in the converging countries for the financial and other products they see in neighbouring or nearby markets. Consumer loans, excluding mortgages, make up just 3% of domestic bank credit in the Czech Republic, 4% in Hungary and 5% in Poland. Mortgages and mutual funds account for 5%, 7% and 4% respectively. In the mature markets of western Europe, overall domestic bank credit as a percentage of GDP is well over 100%.
With the latest additions to the EU fold, and more countries set to join, investors will inevitably look differently at other emerging markets. "The new EU markets have a lower level of political risk than, say, those in Latin America," says Macmillan. "Asia has a greater entrepreneurial spirit but not the same low-cost base."
Russia offers the world's largest energy market and still at extremely attractive valuations, especially given the level of oil reserves of Russian companies. "You can buy the entire quoted Russian energy sector for the price of one western oil company, and the reserves of Russian companies are bigger than the entire western market. But the political risk is still very significant."
China is often cited as a red-hot investment destination, but for most investors it is highly specialist and remote. Foreign direct investment (FDI) into China reached some E323bn in accumulated spending over the last 10 years, against E100bn into converging Europe over the same period. However, the new European countries have a combined population of just 75 million, against China's 1.5 billion people, meaning there is far greater investment per capita into converging Europe than China. That concentration of capital, combined with the relatively highly skilled workforce, is a solid base for long term economic growth.
As more countries seek closer and deeper relations with the EU, how far will Europe's frontiers finally extend? Negotiations are continuing with Romania and Bulgaria, with a view to their joining in 2007. Large countries such as the Ukraine and some of the former Soviet Republic have also expressed interest to join. This year, the European Commission (EC) will also make a recommendation to the European Council about membership for Turkey, assessing whether progress made in its reform process will allow negotiations on accession to start in 2005.
EU officials are developing a 'neighbourhood' policy aimed at creating 'a ring of friendly countries' around the EU, stretching from Morocco all the way along the southern and eastern Mediterranean to Russia. For investors, the opportunity pipeline is long and full, and accession is just the first step.
New EU members commit to eventual adoption of the Euro single currency, although specific criteria as laid out in the Maastricht Treaty must be met first. Preparation to join the euro is guided and encouraged by the EC and other EU institutions. "This is the next big opportunity," says Macmillan. "At the moment, the legal framework provides some comfort but there is still a currency risk to any operation, and extra costs incurred in expansion because of it. A single currency would have a major beneficial effect on cost cutting and risk management."
