On the surface, the future of the enlarged European Union’s 12 newest members (collectively known as the EU12) appears bright as their growth prospects remain buoyant compared with the rest of the EU. However, convergence pains, the struggle to balance growth with stability and a sharp slowdown in developed Europe are beginning to dampen pre-ascension enthusiasm.

“It is a minefield out there for European investors right now,” states Bear Stearns & Co. Inc. ’s fourth-quarter 2007 International Market Strategist report. “The outlook for 2008 is going to be particularly tricky as the economic landscape remains littered with potential traps and pitfalls.”

Average gross domestic product growth in the 27-member EU is expected to fall to 2.4% in 2008 from 2.9% last year. Comparatively, GDP growth for the EU12 is expected to be 5.4%, down from 6.25% in 2007. The EU12’s stock markets have also lost ground so far this year. Romania registered the largest loss (6.6%) on the MSCI frontier markets index, and Estonia the smallest loss (3.8%), as of Jan. 21. This follows strong positive growth among emerging European markets in the past three years.

Despite weakening conditions, Mark Grammer, vice president of investments with Toronto-based Mackenzie Financial Corp., expects emerging Europe to continue to grow on the back of convergence in an expanded EU. He cautions, however, that the region faces the risk of a slowing western Europe and a stronger euro, which will hurt its exports.

Ten of the 12 new members — Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia — joined the EU on May 1, 2004, followed by Romania and Bulgaria on Jan. 1, 2007. These additions have brought the EU’s membership to 27, the union’s largest expansion since it was first established in 1957 as the European Economic Community with six members, thereafter growing incrementally to 15 by 1995. Although the EU’s membership has almost doubled, its total population has increased by about only 25% and its total GDP by less than 10%.

The EU12 offer trade and investment opportunities, a choice of locations, improved economies of scale, reduced costs, lower taxes and increased competitiveness, which combine to make their markets attractive, says Charles Bastyr, portfolio manager and chief investment officer with Meadowbank Asset Management Inc. in Toronto.

On a more macro level, even though the enlarged EU is expected to offer political and economic benefits to Europe as a whole, the underlying rationale for the enlargement has been political. Barring Cyprus and Malta, all the other new entrants 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. As a result, the east/west divide has been bridged for the first time since the end of the Second World War, enhancing regional security and providing political and economic stability.

On average, the new entrants have a per-capita GDP that is more than 50% less than that of the other 15 members (the EU15). Cyprus, the richest of the new members, has a per-capita GDP equivalent to 80% of the EU15 average, while Slovakia, Estonia, Poland, Lithuania and Latvia each have less than 50% of the average. Slovenia, the second-richest of the new members, has a per-capita GDP comparable to the EU15’s poorest state, Greece, which is about 30% below the EU15 average.

In the run-up to membership, the EU12 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. By making infrastructure adjustments to accommodate EU requirements, the EU12 have accelerated their transformation, earning greater credibility and the respect typically associated with EU membership than if they were to pursue individual paths to change.

Ascension to the EU also has led to the abolishment of import duties for manufactured goods, relaxation of capital restrictions and the acceleration of investments in the new members by EU15-based multinationals. The EU has hastened this catchup 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.

@page_break@In addition, lower labour costs in the EU12 have led to a shift in production from high-cost developed Europe to eastern and central Europe, Grammer says. He adds that production in developed Europe is generally more capital- and skill-intensive vs the labour-intensiveness of the EU12 countries. While productivity is generally lower in the EU12, this is more than offset by savings in labour costs.

But despite these perceived benefits, the challenges of expansion have been formidable. The current expansion includes nations with diverse economic characteristics, cultures, wealth and living standards. Essentially, says Bastyr, “Europe is seeking to unify two different worlds.”

Many of the benefits of EU enlargement have also been the source of problems. Members of the EU15 view shifting factories and jobs to low-wage countries in a negative light and as a source of instability, says Grammer. Lower taxes and a flat-tax regime in some EU12 countries also present problems for EU15 members that favour a flexible tax structure, he adds.

“The relocation of labour-intensive industries to the new member states is seen as increasing unemployment in the EU, particularly for unskilled workers,” Bastyr says. For this reason, the movement of labour across borders has been restricted. Corporations are also confronted with legal and administrative barriers, no uniform recognition of academic qualifications, and social barriers resulting from linguistic, diversity and cultural differences.

The major problem with the EU12 is with their governments, Grammer says. He suggests that the hangover from communism weighs heavily on their ability to adopt EU standards, resulting in questions about the depth of democracy in states such as Hungary, Slovakia and the Czech Republic. In addition, some countries, such as Latvia and Romania, are experiencing rising inflation and high current account deficits. “There is need for government reform and better fiscal management,” Grammer argues.

From an investor’s standpoint, Bastyr says, the stock markets of the EU12 are relatively small, liquidity is limited and there are few quality companies of size. Therefore, market growth is largely fuelled by smaller companies that typically grow faster.

Although opportunities remain in selected sectors, such as banking and pharmaceuticals, growth in some emerging European countries will “slow down” because of their dependence on declining trade volumes with developed Europe, says Patricia Perez-Coutts, vice president of AGF Funds Inc. in Toronto: “The natural catalysts in emerging Europe have been convergence and tax incentives” — which are beginning to wear off. She contends that Poland, the Czech Republic and Hungary offer good investment opportunities.

However, large European banks that were hurt by the credit crisis in 2007 have put a hold on many projects, Bastyr cautions, limiting convergence plays and expansionary initiatives. IE