One year after the European Union added 10 new members, the mood across the region is less than euphoric. Despite the expectations preceding the May 1, 2004 expansion, popular support for the enlarged EU has waned, undermining the regional body’s strength.

But while business and consumer confidence in the EU-15 — members prior to enlargement —has deteriorated, significant opportunities remain for investors in selected areas. There is scope to benefit from convergence and mergers and acquisitions, even though, as Chuck Bastyr, managing director and portfolio manager in the Toronto office of BPI Global Asset Management, says, the stock markets in the new members are relatively small, liquidity is limited and it is hard to find companies of size and quality.

Areas to look at include consumer goods, property and financial services as well as more established EU-15 companies that have significant operations in the EU-10.

Demand is high for consumer and financial services products in the EU-10, says Markus Koebler, portfolio manager with Natcan Investment Management Inc. in Montreal.
Domestic participants tend to be unprofitable but EU-15 companies expanding into these markets provide opportunity.

He sees potential in Austrian banks Erste Bank and Bank Austria Creditanstalt; German multinational Metro; and British retailer Tesco PLC, which have expanded to Central and Eastern Europe.

But opportunities come with a host of potential headaches. “The central problem is one of low growth in the mature economies,” says Koebler. Growth in the EU-10 is, on average, two to four times that of the EU-15.

“Individual firms are doing a reasonably good job but are up against a no-growth wall,” adds Mark Grammer, vice president of investment at Mackenzie Financial Corp. in Toronto. “The consumer is weak in the traditional euro zone. There is no employment growth and wage growth is muted.”

These factors impede household formation, says Bastyr. “An aging population puts the region in a position similar to that of Japan — a low-growth macro environment.”

On the political front, ratification of a new EU constitution that reaffirms membership commitments is one of the most tenuous issues. So far, 10 countries — Austria, Germany, Greece, Hungary, Italy, Latvia, Lithuania, Slovakia, Slovenia and Spain — have agreed to accept the new constitution but the French and the Dutch, two of the founding members, have voted not to ratify it.
There is also a risk Denmark, Poland, Czech Republic, Britain and Luxembourg may vote against it this summer, putting the union on shaky ground.

All 25 EU members must ratify the constitution. If by November 2006, 80% have ratified it but the others have not, an EU summit will be held to consider the situation.

Surprisingly, the administrative process of facilitating the largest expansion since the EU was first established in 1957, was smoother than expected. But new members have yet to be fully accepted as part of a unified regional body and are regarded as “second cousins” to more established members.

They will remain outside of the passport-free travel zone for at least another two years.
Their citizens do not yet have the freedom to work in member countries of their choice, with only Britain, Ireland and Sweden opening up their labour markets. Their farmers get lower direct subsidies, even though their agriculture base is significantly higher. They are also several years away from being part of the region’s single currency, the euro.

“Europe has sought to unify two different worlds: countries with diverse cultures, different levels of wealth and varying economic characteristics,” says Bastyr.
“Previous EU enlargement involved countries with similar economic structures.”

On average, new entrants have a per capita GDP 56% lower than that of the EU-15.
Cyprus, the wealthiest new member, has a per capita GDP equivalent to 80% of the EU-15 average; Slovakia, Estonia, Poland, Lithuania and Latvia each have less than 50% of the average. Slovenia, the
second-richest newcomer, has a per capita GDP comparable with the EU-15’s poorest state, Greece, which is about 30% below average.

Barring Cyprus and Malta, the other new members — Czech Republic, Estonia, Hungary, Lithuania, Latvia, Poland, Slovakia and Slovenia — were part of the former Communist Bloc. They 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.

@page_break@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. Although all new members have not fully met the established criteria, they have been allowed a transition period to put their houses in order.

By making infrastructural adjustments to accommodate EU requirements, the new member countries have 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. “In Eastern Europe, for most countries joining the EU, country risk has declined further under the effect of EU membership and the recovery in growth since 2003,” says the March 2005 Quarterly Overview on Country Risk, published by the Paris-based international bank, BNP Paribas.

At a macro level, enlargement has brought political and economic benefits to Europe as a whole, as well as to individual member countries, including enhanced regional security and political and economic stability.
The new EU members offer trade and investment opportunities, a choice of locations, improved economies of scale, reduced costs, lower taxes and increased competitiveness.

But many of these benefits have been the source of problems within the EU. More established countries view shifting factories and jobs to low-wage countries in a negative light and as a source of instability. Lower taxes and a flat-tax regime in some countries also present problems for EU-15 members who favour a flexible tax structure.

“The relocation of labour-intensive
industries to the new member states could increase unemployment in the EU, particularly for unskilled workers,” Bastyr says. On the whole, production in the EU-15 is more capital- and skill-intensive whereas the new countries are more labour intensive.
For this reason, the movement of labour across national borders has been restricted.

Other barriers present challenges to an enlarged EU. An April 2005 report prepared by the Paribas economic research department sums them up: “Corporations are confronted with judicial and administrative barriers resulting from the incompleteness of the single market, which lead to higher prices, insufficient growth and lower levels of trade than 10 years ago.”

The report also identifies legal barriers related to a lack of recognized qualifications, nationality and/or residency; and social barriers because of linguistic, diversity and cultural differences.

On the positive front, import duties for manufactured goods have been abolished; capital restrictions have been relaxed; and EU-15 multinationals have stepped up investment in the new countries. The EU is also accelerating 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. IE