REPORT FROM THE COMMISSION - Economic Reform : report on the functioning of community product and capital markets {SEC(2002) 1399 final}

Executive summary.

The competitiveness gap between the USA and the European Union is widening and there is a risk that the US economy will outperform the European economy during the downturn just as it did during the economic expansion of the late 1990s.

Against this background, this fifth report on the functioning of product and capital markets first takes its cue from the Barcelona European Council which put the emphasis on the implementation of policy guidelines. It looks at the implementation of the economic reform guidelines laid down in the conclusions of successive Internal Market Councils and concludes that there is a wide gap between policy intentions and achievements.

Second, this report looks at economic reform and integration indicators and identifies some economic areas requiring urgent reform and a greater effort from the Member States. The scope for integration seems far from exhausted, but price convergence has stalled, which is bad news for consumers. The services sector, including financial services, must be the top priority for closer integration.

Third, the report presents estimates of the benefits that economic reforms can bring, especially in financial services markets and of actual costs borne by European citizens and businesses now as a result of delays in the introduction of reforms. The potential gains - and thus the costs of inaction - are huge.

The overall picture of implementation is mixed with approximately 50% of the guidelines issued by the Internal Market Council satisfactorily implemented and 50% showing less than satisfactory outcomes. But 50 % is nowhere near enough to reach the Lisbon target and must be improved.

Only in a minority of cases is the implementation record clearly unsatisfactory. But these include major planks of economic reform for improving competitiveness identified by the Internal Market Council as important and urgent, notably a new legislative package for public procurement and the Community patent, both of which have yet to be adopted.

In summary, although some progress has been made with implementation, the adoption and implementation of economic reforms in product and capital markets remain sluggish.

Are we on schedule with the introduction of economic reforms in order to achieve the competitiveness objectives established by the Lisbon European Council?

Using the past 10 years of Internal Market legislation as a benchmark for the timing of reforms, we can conclude that despite these delays, we may still be on time to reach our Lisbon deadlines, but only if adoption of proposals currently under consideration is not further delayed and if Member States transpose directives on time.

For instance, between 1993 and 2002, in financial services, the average period from the presentation of the Commission proposal until the last Member State actually implemented the directive was over 7 years. We cannot afford these delays in the future. A firm commitment by Member States to speed up the introduction of reforms through swift adoption and diligent transposition is essential for achieving our goals on time.

The procedures for the adoption of implementing measures proposed by the Lamfalussy report and currently applied for the adoption of measures included in the Financial Services Action Plan should help speed things up.

What do economic reform and integration indicators show about market performance?

Foreign direct investment remains the leading driver of cross border activity especially in services but it was severely hit by the economic downturn in 2001 and fell below 1999 levels. Intra-EU trade in goods has grown faster than GDP between 1996 and 2000, but it lost momentum in 2001, a year when world trade fell for the first time in two decades. But the Internal Market still has further potential for integration. Even Belgium and Luxembourg, long-time EU members with traditionally open economies, have been able to create more trade with other EU members and non-EU countries in recent years.

It is interesting to note that Internal Market rules have been able to create more trade without generating relatively more « market friction » as reflected by infringement cases. The growth path of trade (measured by imports) and Internal Market rules infringements (excluding transposition cases) diverged in recent years, with trade growing and infringements remaining stagnant. In addition, intra-EU trade has not been created at the expense of trade with the rest of the world. On the contrary, the EU has become more open to trade in recent years.

Indicators have confirmed stagnation of consumer price convergence and this is a serious matter of concern and a good argument to speed up the introduction of reforms, not least because price convergence has been particularly positive for consumers. Goods showing high price convergence tend to show lower price increases. An absence of price convergence and higher than average price increases also go together.

The creation of the Internal Market for services is perhaps the most important mid and long term goal for reforms. Now we know that the ability to benefit from the use and diffusion of information and telecommunications technologies especially in services sectors and in particular in retail distribution and securities, is a major factor for explaining differences in the competitive performance of the USA and the EU economies.

The objectives of the Lisbon European Council are not achievable without the creation of a real Internal Market for services, especially in services that affect the competitiveness of businesses across all sectors. Some of the benefits of the Internal Market are being squandered now due to the poor performance of the services sector. Independent action by Member States is necessary, but not sufficient for making significant progress in this area. The development, adoption and implementation of the service strategy is therefore becoming increasingly urgent.

Completing work in the financial services sector is particularly important because it will boost the competitiveness of all sectors. Significant progress can be reported in the introduction of reforms in this sector with ¾ of FSAP measures already adopted. Indicators show that integration is making progress too, especially in wholesale markets. Today, cross border activity represents 60% of total activity in the unsecured money market. However, integration continues to be hampered by lack of harmonisation of rules and practices on collateral use, clearing and settlement, accounting practices and requirements for prospectuses. The potential benefits from full integration in these markets are huge. The one off macroeconomic impact of pooling liquidity in European equity and corporate bond markets has been calculated at 1.1% of EU GDP in 2002 prices, or EUR130 billion, with gains in terms of employment at 0.5%. Investment could also grow by 6%.

Retail financial markets show much lower levels of integration. The consumer loan segment shows no signs of integration at all.

Benefits from providing companies access to liquid markets throughout the EU have been estimated at between 0.74 - 0.92% of the value added of the manufacturing industry. SMEs would be the main beneficiaries of more diversified sources of financing: a 10% drop in bank-based financing in favour of capital market financing would reduce financing costs by the equivalent to 0.3% of EU GDP. Potential savings from the elimination of inefficiencies in the financial sector caused by lack of integration are far from negligible. In the EU banking segment they can be estimated to total between 1.4 and 1.6 % of GDP. These costs are currently at least partially passed on to firms and consumers.

By speeding up the implementation of reforms in financial services, we can bring these benefits on stream sooner. Further delays will mean that these gains are being squandered.

Public procurement markets reforms are in the pipeline, but have been badly delayed. The few indicators we have for measuring integration in this market show that little to no progress has been made. For example, the number of cross-border award notices remained abysmally low, accounting for just 1.26% of total award notices in 2001. The European economy thus continues to be deprived of the benefits that could accrue from the integration of such a large and important economic sector. A mere 1% of savings as a result of more competition would have released EUR14 billion in 2001 to be spent more efficiently or to allow reductions in the tax bill. This is equivalent to approximately one third of the total net financing needs of public administrations on that year.

Finally, the significant efforts expended on reducing the regulatory burden on SMEs and start-ups should be complemented with the full and effective implementation of the action plan for better and simpler regulation. The annex to this report, based on a questionnaire to Member States, shows that the "Internal Market" dimension of improving the regulatory environment is often neglected. National administrations need to take into consideration not just the impact of regulation on domestic economic actors, but also on other EU actors trying to exercise their Internal Market rights.

I. Introduction

The competitiveness gap between the USA and the European Union is widening [1] and there is a risk that the US economy will outperform the European economy during the downturn just as it did during the economic expansion of the late 1990s.

[1] See SEC(2002) 528 "2002 European Competitiveness report" for a detailed account of the evolution of competitiveness.

Against this background, this fifth report [2] on the functioning of product and capital markets first takes its cue from the Barcelona European Council which put the emphasis on the implementation of policy guidelines. It looks at the implementation of the economic reform guidelines laid down in the conclusions of successive Internal Market Councils and concludes that there is a wide gap between policy intentions and achievements.

[2] The Cardiff process of economic reform has been the subject of an in-depth review by the new Competitiveness Council. On 30 September 2002, the Council took note of the conclusions of a report titled "Review of the Cardiff economic reform process from the internal market perspective." This fifth Commission report on the functioning of product and capital markets has been structured to respond to this and other developments.

Second, this report looks at economic reform and integration indicators and identifies some economic areas requiring urgent reform and a greater effort from the Member States. The scope for integration seems far from exhausted, but price convergence has stalled, which is bad news for consumers. The services sector, including financial services, must be the top priority for closer integration.

Third, the report presents estimates of the benefits that economic reforms can bring, especially in financial services markets and of actual costs borne by European citizens and businesses now as a result of delays in the introduction of reforms. The potential gains - and thus the costs of inaction - are huge.

It would be remiss if this report did not acknowledge the 10th anniversary of the removal of frontiers in the Internal Market. This is a good occasion to draw lessons from the experience of those past 10 years for the process of economic reform that still lies ahead. The adoption and implementation of Internal Market legislation to date helps us understand how long it takes to achieve economic reforms, and highlights the risk of missing our targets due to delays in the proposal, adoption and implementation of reforms.

The report conveys the following messages:

(1) The Internal Market still holds potential for growth and job creation, but economic reforms are needed to reactivate trade and integration as shown by stagnant price convergence;

(2) The analysis of potential benefits and costs of inaction show that reforms in financial markets are urgently needed in view of their great potential and market developments. Priority should also be given to the creation of the Internal Market for services because it is essential for achieving the competitiveness targets established at the Lisbon European Council. The rapid adoption and diligent enforcement of the new public procurement legislative package and the implementation of the better regulation package complete the list of priorities. Parallel progress in all areas of reform is the key to succeeding in the broader effort of reforming product and capital markets within the Community;

(3) The analysis of implementation shows that some progress has been made, although the adoption and introduction of economic reforms in product and capital markets remain sluggish. Only a firm commitment to speed up adoption and enforce reforms can guarantee meeting the Lisbon timetable for our competitiveness objectives.

The next section presents the main results of the monitoring of overall market performance using price, trade and foreign investment indicators. Then, the results of the monitoring of especially relevant markets are presented. This includes public procurement and financial markets. Annex 1 of the report includes graphs, tables and technical material relevant for the report. In addition, this year's report includes two special annexes. Following the conclusions of the report on the Cardiff economic reform process conducted by de Competitiveness Council, annex 2 presents a more detailed analysis of the two topics selected by the Council : measures taken by Member States to remove barriers to integration in services and to modernise and simplify national legislation and administration procedures. As in last year's report and given the special importance of services of general interest, annex 3 is exclusively dedicated to them. It includes updates of the main indicators and the results of a Eurobarometer reporting consumers' views on the performance of these sectors.

II. Taking stock of economic reform.

The Cardiff process has produced a significant number of orientations to foster economic reform [3]. It is time to evaluate the extent to which they have been implemented. That is the purpose of this section.

[3] The focus here will be on Internal Market Council conclusions only. Recommendations from the Cardiff process are also included in the Broad Economic Policy Guidelines issued by the ECOFIN Council, which are analysed in detail in their implementation reports.

The 60 main policy orientations issued by the Internal Market Council in the context of the Cardiff process are summarised in tables 1 to 3. Some of them required intervention at the Community level, while others were addressed at the Member State level. In both cases, we distinguish between those requiring action related to the production, adoption or enforcement of legislation or regulations and those requiring non-legislative action such as monitoring or the development of out-of-court conflict resolution mechanisms.

These orientations vary in scope and importance. For instance, "the implementation of the Financial Services Action Plan" includes 42 measures and cannot be compared in importance with others like the "enhancing cooperation for the collection of statistical data". Furthermore, some proposals are revised versions of previous ones [4]. Despite the limitations this implies, these tables can give an overview of the evolution and results of the process.

[4] Only the first formulations of orientations that have been revised are presented here. The year of first formulation is included in the parenthesis. This undoubtedly masks important qualitative changes in their nature. For instance, the 1999 conclusions mentioned the need to integrate energy networks and make them interoperable. However, the 2001 conclusions on network integration elaborated and clarified the 1999 conclusions.

To date, the majority of the items included in the Internal Market Council conclusions have been legislative or regulatory in nature. Although 23 of them were not legislative or regulatory, economic reform has relied heavily on the proposal, adoption and enforcement of new rules. It is interesting to note that relatively few of the non-legislative orientations were addressed to Member States (six out of 23).

In the tables, we have also summarised the implementation status of each orientation. We created three categories of results: satisfactory, less than satisfactory and clearly unsatisfactory. Undoubtedly, this is a simplified and rough assessment, but it is helpful for obtaining a global picture of the outcome of the Cardiff process thus far [5].

[5] This assessment is based on a large number of scoreboards (e.g. the Internal Market, State aid, enterprise policy, innovation scoreboards) Commission communications, FSAP and RCAP implementation reports and other reports.

The overall picture of implementation is mixed, with approximately 50% of all cases showing fully satisfactory results and the other 50% showing results that are less than satisfactory or unsatisfactory.

The overall picture from this assessment seems more positive at Community level with 25 satisfactory results. Only 6 proposals show a clearly unsatisfactory outcome. However, some of the most important orientations show an unsatisfactory or less than satisfactory outcome [6]. Box 1 presents a summary review of implementation by areas.

[6] Orientations requiring action at Community level show the highest percentage of both clear success (23 out of 40) and clear failure (6 out of 40). Results are less extreme for those requiring intervention at Member State level.

It is important to note that major planks of economic reform that were included in Internal Market Council conclusions for the first time nearly three years ago, have still not been adopted: a new legislative package for public procurement (1999) and the Community patent (2000). In view of all this...

...Are we on schedule with the introduction of economic reforms in order to achieve the competitiveness objectives established by the Lisbon European Council?

The Internal Market experience offers some good benchmarks for the actual time required to realise economic reforms when new legislation has to be adopted and implemented at the Community level. From these benchmarks, we can project out the time that will be required before proposals currently being discussed at the Council or Council/Parliament will be effectively implemented.

We have selected 731 [7] Internal Market directives proposed and adopted between 1993 and April 2002 and measured the following dimensions:

[7] We calculated the average adoption phase for 731 directives (44% were Commission directives, 30% Council directives and 26% were adopted by the Council and the European Parliament). The average legal transposition phase was calculated for 695 directives because 36 did not have a transposition deadline. The average delay phase could be calculated for 401 directives because full transposition has not been achieved for 294 of the 695 directives. These 294 directives in turn fall into two subgroups: a) the transposition deadline has not passed yet (115); and b) measures have not been notified and/or because there are open infringement procedures for transposition reasons (179).

- Average adoption period, i.e. average time between proposal by the Commission and adoption by the relevant legislative bodies at the Community level;

- Average legal transposition phase, i.e. average time between adoption at the Community level and deadline for transposition at the Member State level;

- Average delay phase, i.e. average time between transposition deadline and date that the last country has effectively transposed and enforced the directive [8].

[8] For this exercise, a directive is considered effectively transposed and enforced when it is completely and properly transposed in all Member states where it is supposed to be transposed and there is no open infringement proceedings for implementation reasons.

On average, adoption took 1.18 years and legal transposition took 1.10. This means that the average time required for adoption plus legal transposition of Internal Market directives adopted between 1993 and April 2002 was 2.28 years [9].

[9] These figures are better than those for Internal Market directives adopted between 1985 and 1992: average adoption time for these directives was 1.7 years and legal transposition was 1.28 years.

Adoption took longer on average if the directives had to be adopted by the Council and European Parliament (2.57 years) than if they only had to be adopted by the Council (1.72 years). However, this is not the case for all sectors; for example, co-decision directives for pharmaceutical and chemical products took on average 1.68 years, whereas Council directives for the same area took 2.58 years on average.

But undue delays in transposition beyond the established deadline are the major reason for the late introduction of reforms: the average delay phase nearly doubles the total time required for adoption or legal transposition.

Transposition problems beyond the due deadline extend the average time needed to have Internal Market directives effectively implemented by 2.21 years. This results in an average global time path for the effective implementation of these directives of 4.49 years.

These average figures vary quite remarkably across sectors. Figure 1 shows the average global time path by aggregated field of 403 post-1992 Internal Market directives [10]. Financial service directives show an average global path of 7.33 years. Social policy directives, environmental directives and consumer protection directives also show high average global time paths. This is the result of higher than average adoption time (2.56 years for financial service directives) and total transposition time (including delay period, 4.77 years for the same sector (see table 4). Environment related directives show the longest delay phase with 3.34 years (see table 5 and box 2).

[10] In fact, when we consider the global time path of framework directives it is much longer than for the secondary directives considered here (see figure 1).

These figures show clearly that we may be on time to reach our deadlines laid out by the Lisbon European Council if adoption of proposals currently under consideration is not delayed any further, and if transposition is not prolonged beyond the due deadlines. A firm commitment by Members States to speed up the introduction of reforms through diligent adoption and swift transposition is necessary for achieving our goals.

Given these circumstances, it is necessary to ensure that the transposition phase does not go beyond the technically minimum time needed for effective implementation by national authorities [11].

[11] Significant delays have already accumulated the adoption of the public procurement package, the Community patent regulation and the sales promotion proposal. However, the latter two are regulations though and consequently do not require transposition.

The costs of delaying the implementation of these and other reforms would be significant. The sections below provide some estimates of the potential benefits to be obtained from reforms. Initially, we examine overall market performance indicators of the Internal Market and then we dive deeper and look at the performance of specific markets (financial services and public procurement) particularly important for the European economy.

III. Results of overall market performance monitoring.

Implementation of economic reform measures is essential for achieving the long-term policy objectives defined at Lisbon in March 2000, but economic reform does not end with implementation. The European economy will only become more competitive if the measures produce the intended effects. Price, trade and cross-border investment data show to what extent economic reforms and Internal Market policies are effectively fostering integration and competition, expanding job creation and growth potential. A look at price convergence in private consumption is particularly telling of changes occurring in consumer markets.

Prices: New evidence confirms the slowdown in price convergence identified last year.

Final data for 1999 and 2000, and preliminary data for 2001 show that the clear pattern of price convergence in private consumption of the 1990s seems to slow down. However, the relative increase in price dispersion observed last year is not confirmed. Price dispersion, as measured by the coefficient of variation, was 14.7% in 1999 (14.5% in 1998) and increased to 15.3% in 2000. Preliminary data for 2001 bring this indicator close to the 1999 level, i.e.14.6%. What is causing the stagnation in convergence?

Where is there still room for convergence? In which countries and product markets has price convergence occurred and where can it be pushed further? A look into the convergence patterns by countries and product categories will help answer these questions.

Member States show different patterns of price convergence.

While figure 3 shows that stagnation in price convergence is common to most Member States, it also reveals four very different patterns in the price convergence that has occurred during the 1990s.

- There is a first group of countries, composed of Austria and the EU 6 founding Member States, that now exhibit a very tight level of price convergence among themselves. Price dispersion among these countries is minimal (2.9%).

- A second group of countries has also undergone a significant process of convergence in prices, but remain above and below the EU average price levels without any appreciable convergence. In this group, Finland is above EU12 average prices, while Spain, Portugal and Greece have below EU9 average prices.

- The three countries outside the eurozone, UK, DK and SW show prices above EU15 average and their relative price levels fluctuate in terms of price convergence. SW and the UK seemed to follow a diverging trend in 1999 and 2000, but they converged slightly in 2001 according to preliminary data. Exchange rate fluctuations can probably explain in part this behaviour.

- Ireland was among the below EU9 average group until the mid 1990s but they have overshot the EU9 average in recent years (see figure 3). Ireland's impressive growth seems to have put upward pressure on prices shifting Ireland's profile.

Prices of different goods and services have not converged at the same time or in the same way.

In the early 1990s, some products/services showed extreme price differences across countries. This was especially frequent in countries with either very low or very high average price levels (see figure 4). The creation of the Internal Market narrowed these extreme price differences between 1990 and 1995. Then, in the mid 1990s, "typical Internal Market goods," such as clothing, sports goods and household appliances, tended to experience the best price convergence, but the rate at which prices converged slowed because by then, extreme price differences had already been eliminated. Other product categories, such as fuel, power, tobacco and floor coverings, did not experience the same level of price convergence, and in some cases, even diverged.

But, have consumers benefited from price convergence? ... Yes, in many cases...

Consumers only benefit from price convergence if prices converge toward price levels in low price countries. If prices converge at high price levels (e.g., because of a lack of competition), consumers will not benefit from the creation of an Internal Market. Table 6a shows that for a large number of goods, prices have converged to low price levels. Many food products, including meat, fish, bread, oils/fats, beverages, beer and some consumer electronics goods, show clear convergence towards low price levels. For example, differences in the price of cooking oil and fats were reduced by 44% and prices grew at an average annual rate of 1%, well below the inflation rate for most consumer goods. Actually, this positive impact of convergence on prices is not negligible from consumers' point of view. Products in table 6a showing this good price performance, i.e. products showing high price convergence and lower than average inflation, represent 25% of private final consumption (see table 6b) [12].

[12] Of course, the evolution of prices depends on many factors besides integration. The evolution of factor prices such as fuel or labour, technology, intermediate inputs and productivity have a significant impact on the prices of goods and services.

... but not always!

However, there are still many areas, particularly in services, where integration and competition could produce increased price convergence to the benefit of consumers. Automobiles, glassware, tobacco, books and travel-related insurance are among them. In these cases, prices are now further apart than they were in the early 1990s. Furthermore, prices in these product segments have been rising faster than the rate of inflation. In addition, most of the services included in table 6 have exhibited poor price performance, reinforcing the case for the creation of a real Internal Market for services. Integration has not always resulted in tangible consumer benefits in some goods/services markets, and it is on these markets that our attention should be focused in the future [13].

[13] The performance of services prices is a matter of concern both from the point of view of integration and the overall evolution of prices. In this context it is important to remind the mandate given by the ECOFIN Council to the Commission to have a closer, in-depth look into the causes for price inflation/differentials across Member States and, in particular, in the services sector.

The observed slowdown in price convergence seems to result from the exhaustion of the initial shock-wave effects of the creation of the Internal Market and successive accessions The slowdown has been observed in all countries except for the UK, Ireland and Sweden where there is some trend towards divergence. There is substantial potential for further convergence towards lower prices in several product categories.

What kind of action may be useful to push convergence further?

At the broadest level, the strict enforcement of Internal Market law and competition policy can go a long way towards the prevention of fragmentation in the Internal Market and the creation of healthy competition. Other regulatory reforms such as the opening up to competition of network industries can also foster competition. The greater development of cross-border shopping by consumers and e-commerce [14] can also contribute to price convergence by exerting downward pressure on prices. Of course, all sectors are not equally open to cross-border shopping. However, the advent of euro coins and notes could also help narrow price differences too.

[14] The green Paper on EU Consumer Protection (COM 2001 531 final) and its follow-up communication (com 2002 289 final) address these issues in particular from the perspective of consumer confidence and protection and make proposals for strengthening this aspect of the Single Market.

Within specific goods and services markets though, we need to look more deeply at specific factors that impact price convergence. In previous reports we have identified indirect taxation, the structure of distribution networks, market power and inefficient services sectors as composing a significant portion of residual price differences. How much do these factors account for the remaining price dispersion? The car market offers a good example of the different ways in which integration can be pushed further.

One study of the new car market determined that large price differences persist across countries regardless of whether price differences are measured with or without taxes. Incomplete pass-through of taxes creates large pre-tax differences in the prices of new cars. The study shows that pre-tax price differences on new cars could be reduced by 16 percent if tax distortions were removed [15].

[15] See "Car Price Differentials in the European Union : An Economic Analysis" by H. Degryse and F. Verboven for DG Competition, November 2000.

The distortions due to differences in taxation spill over into the spare-parts markets as well. As shown in box 3, there seems to be an inverse relationship between the price levels for new cars and spare parts (both measured pre-tax). Pre-tax prices for new cars tend to be lower in high tax countries in order to compensate for the negative effect of high taxes on demand, while spare-parts prices seem to be higher in those countries, thereby compensating for lower revenues from new car sales. As a result, tax differences result in price distortions in two markets (market for new cars and market for spare parts) and total price dispersion increases in the Union.

Two recent developments can trigger further convergence in the car sector.

- The recent Commission communication on the taxation of passenger cars (COM[2002] 431) recommends that registration tax levels should be gradually reduced, maintained at low levels and preferably abolished over a transitional period of five to ten years. Incorporating this recommendation into national tax systems should help reduce fragmentation of the new car market.

- Commission Regulation (EC) No 1400/2002 of 31 July 2002 on the application of Article 81(3) of the Treaty to categories of vertical agreements and concerted practices in the motor vehicle sector will curb market power. It will also help rationalise and restructure car distribution and servicing.

A large potential for price convergence lies in the services sectors which will likely require even greater reforms. Figure 5 shows the price patterns of three very different types of services: car insurance, dry cleaning and car rentals. In all of these cases, price convergence has been low to non-existent, and prices have been rising faster than the rate of inflation. It is important to point out here that in addition to the benefits that would accrue to consumers just from being able to access services at cheaper prices, downward price convergence in the services sectors (e.g. distribution, transport, energy, business and financial services) would also lower the cost of manufactured goods and thereby create additional benefits for consumers.

Enlargement offers possibilities for additional gains for consumers in the Internal Market.

The inclusion of new member states into the Internal Market has the potential to unleash new competitive pressures within the market and deliver even greater benefits for consumers. Figure 8 shows the price level in the present 15 Member States and in the accession and candidate countries with respect to an EU25-average. The ten new countries, with the exception of Malta and Cyprus, all have price levels significantly below any of the EU15 countries. Thus, price differences will be much larger in an enlarged EU. For most product segments, price dispersion in the new EU25 will be higher than it was during the launch of the Internal Market with the EU15 at the beginning of the nineties (see figure 9).

While we will undoubtedly see convergence in the EU 25 during the coming ten years, the inclusion of new countries could also spark increasing convergence among the EU15. Within the EU15, the low and high price level countries are geographically far apart from each other, which slows down integration. However, in an enlarged EU25, high price level countries will be located closer to low-price countries. Consumers in countries with high price levels like Sweden for example, could benefit considerably from increased competition from the Baltic States and Poland. Of course, this is a possibility that can be realized only if the opportunities created by enlargement for all countries involved are fully exploited.

Trade: Integration continued increasing steadily between 1995 and 2000 ... but lost momentum in 2001!

Intra-EU trade flows in goods have consistently increased at a rate greater than European GDP growth between 1995 and 2000. Furthermore, the intra EU goods imports share of national apparent consumption has been increasing (14 % on average for EU 15 in 2001). However, and for the first time since the creation of the Internal Market, intra-EU trade in goods as a percentage of GDP did not grow in 2001 over the previous year, because GDP grew faster than trade (see figure 10). This may be an isolated event of limited magnitude. In addition, 2001 has been an exceptional year and world trade has stopped growing for the first time in two decades. Nevertheless, this development calls for a more careful look at trade evolution and shows the need to exploit in full the trade creation potential of the Internal Market. [16].

[16] Everything concerning trade and investment in the services sectors is discussed in the annex.

The trade openness of EU countries towards extra-EU zones has increased more rapidly than their openness towards each other.

Excluding 2001, world trade and extra EU trade (exports plus imports) have been growing faster than intra EU flows. The value of EU imports from extra EU providers nearly doubled from 1995 to 2001. This pattern has been consistent in all EU countries (particularly in Austria, Greece, Germany and the Netherlands) (see table 7). This has two important implications. First, contrary to what has sometimes been alleged, economic integration within the Internal Market is not creating a "Fortress Europe"; and second, this trade pattern (internal + external trade creation) means that every effort to remove remaining barriers to trade within the Internal Market has the potential to create real welfare gains, because increased intra EU trade does not substitute for extra EU trade.

Significant differences remain across countries in trade creation and trade openness.

Only 6 Member States, Germany, Austria, Belgium/Luxembourg, France and Spain, display clear signs of increased intra-EU trade flows. Finland and the Netherlands have shown a moderate increase in intra EU openness in the 1995-2001 period, but the remaining EU countries have not exhibited remarkable changes in their intra EU openness or, as in the cases of UK and Greece, have even reduced intra EU trade in the same period (see table 8).

Obviously, the relative openness of each individual economy at the outset of integration is an important factor for evaluating these results. One would expect that the older EU Members with more integrated and open small economies would have exhibited a less dynamic integration pattern in recent years, whereas the biggest and least open economies would only now be exploiting their trade integration potential. But this has not always been the case.

Among the countries with relatively good trade creation performance we find long-time EU Member States with a highly open economies in 1995 like Belgium and Luxembourg alongside « newcomers » like Austria, which had a relatively open economy at the moment of accession. In the bigger and relatively closed economies with long (France and Germany) and shorter (Spain) EU membership, significant trade volumes have also been generated in recent years. Other countries with highly open economies in 1995 show some symptoms of exhaustion in trade creation between 1995 and 2001. Finally, long time Members with relatively closed and bigger economies (Italy, and the UK) and more recent Members with relatively more open and smaller economies (Portugal, Greece and Sweden) exhibit relatively worse trade creation performance (see table 9).

The cases of Belgium and Luxembourg show that the Internal Market still offers the potential for significant trade creation for long-time members with already highly integrated economies, as well as for new members like Austria. In fact, comparing the trade performance of the three most recent countries to join the EU since their accession in 1995 throws very interesting results. Their trade performance has been completely uneven: among the three, only Austria has met expectations, whereas Finland has experienced only a moderate increase in intra EU openness and Sweden has experienced very little trade integration at the aggregate level.

Trade has been created with relatively less "market friction".

The Internal Market has succeeded in creating more trade in a market with relatively less "friction". Figure 11 shows that trade (imports) has been growing faster than the number of Internal Market infringements non-related to transposition problems. In fact, between 1988 and 1994, intra EU trade and infringements grew apace. However, after 1995 there is a clear change in the trend showing that trade could grow steadily while the number of infringements fell and then grew at a much lower rate.

This indicator of market friction can also be useful to complete the profile of Member States. Figure 12 shows the ranking of countries taking into account their integration in the Internal Market and the number of infringements non related to transposition. This index is high for countries with a high number of infringements opened in the 1995-2001 period and low imports and incoming foreign direct investment.

Intra EU-trade performance could be improved with better application of the mutual recognition principle.

In addition, convergence, including necessary harmonisation, of national measures is required up to the point where mutual recognition becomes possible.

In the light of experience, these harmonisation measures may be needed in areas which are relevant to significant health, environment and consumer protection issues [17].

[17] Eurobameter 57.2 - Flash Eurobameter 128 : Public opinion in Europe : Views on business-to-consumer cross-border trade, 14 November 2002

The correct application of the mutual recognition principle still presents problems. About a third of the infringement proceedings during the period 1998-2001 involved issues of mutual recognition. However a number of measures proposed in the 1999 Communication on Mutual Recognition have already been implemented. In addition, the notification procedure under Directive 98/34/EC is proving to be extremely useful as Member States are now adopting large amounts of technical regulations due to technological change and health and food safety issues (in 2001 the Commission received 530 notifications of technical regulations).

The recent report on the application of the principle of mutual recognition evaluated the functioning of this principle based on evidence provided by case studies and infringement cases...

...but what can be said about the overall impact of the principle of mutual recognition on integration? How does it compare to harmonisation measures?

Convergence in unit export prices is a relatively rough indicator of integration, but it offers some comparison of the performance of trade in harmonised and non-harmonised products [18]. Between 1993 and 2002, the dispersion of export unit values has been on average lower in the EU than in OECD countries.

[18] M. M. Knetter and M. J. Slaugther «Measuring product-market integration» NBER, February 1999 and Gil-Pareja, S. (2002): "Export price discrimination in Europe and exchange rates", Review of International Economics 10, 299-312.

Over 80 % of the sample products exhibit lower dispersion in the EU than in the OECD at the end of the period (see table 10). Export unit values inside the EU have converged more intensively than in the OECD as a whole. For the vast majority of EU countries, more than 50% of export goods show converging unit values (see table 11).

Non-harmonised products are among those demonstrating the greatest levels of export unit value convergence: 19 among the top 50 sectors in the export unit value convergence ranking are not covered by any kind of harmonisation, 6 are harmonised goods and 16 of them are covered by new approach directives (see table 12).

But in those cases where the free-movement of goods principle doesn't work properly, firms and consumers pay a high cost.

For instance, in the lorry sector, the main difficulties arise from the compulsory technical rules of Member States. These rules often create unnecessary extra costs for traders and/or firms and negatively impact trade flows and prices, generating welfare losses for consumers and producers. In particular, the impact is felt in the form of product modifications to achieve compliance, added costs for testing every new model, and delays in time to market due to administrative procedures.

In the case of the lorry sector, Commission case studies have shown that the additional cost for exporters to adapt their products to national requirements ranges from 1785 EUR to 2500 EUR per vehicle. Analysis of export unit values confirms that these additional costs are passed on to consumers.

Despite recent developments the internal market program still hasn't exhausted its trade creation potential as confirmed by the case of Belgium. Therefore, there is a strong case for eliminating remaining barriers in order to allow other EU economies to fully exploit this potential and benefit from the important economic gains that are now to being lost. The case for further liberalisation is even greater for the services sector, where trade has not taken-off yet (see services annex).

Recent figures show that foreign direct investment remains the main driver of integration in the EU, but it was seriously hit by events in 2001.

Intra EU FDI flows increased by a factor of 15 between 1995 and 2000 and was seriously hit by events in 2001, falling below 1999 levels. This sudden and important downturn in FDI activity shows the high volatility of these flows and their sensitivity to short term economic conditions.

The analysis of the longer run trends shows that, unlike trade, there is a clear reorientation of flows towards the EU area : in 1995, the share of intra EU flows was already higher than that of extra EU flows and the gap has been increasing until 2000.

Leaving aside 2001, the ratio of trade to FDI has been rapidly decreasing. Several countries which have shown only modest progress in trade integration have proven to be very dynamic in intra FDI flows; in these cases FDI, and not trade, has been the main instrument for internal integration (e.g. UK, Sweden). (See figures 13, 14, 15)

IV. Results of the monitoring of especially relevant markets

The overall assessment based on general market indicators must be complemented with an analysis of the performance of some markets of special importance from the Internal Market point of view. In this section we look into the situation in public procurement and financial service markets. In an annex we present an update to last year's evaluation of services of general interest [19].

[19] The new methodology defined in the recent Commission Communication for the horizontal evaluation of services of general interest will be applied from next year on.

Public procurement markets

Total public procurement's share of GDP has declined from 17.3 % in 1995 to 16,2% in 2001 (see table 13). However, increasing transparency and effective competition in public procurement markets remains one of the most important and challenging objectives of the Internal Market. Integration of these markets could still yield large benefits.

One percent savings in public procurement as a result of more competition and efficient public procurement markets would have resulted in total savings of EUR14 billion in 2001 for EU 15. This is equivalent to approximately one third of the total net borrowing needs of public administrations during that year. The potential for savings in this area is therefore important, especially in the current context of improving the quality of public spending.

Recent developments in this area have given us new reason for concern and added impetus for the adoption of the package ...

First, the percentage of public procurement that was published in the Official Journal (i.e. disclosed to the public) did not grow significantly in 2001 and remained at 15.8% (see table 14). After a promising 4 percentage points increase in 2000, this stagnation in the transparency of public procurement markets is a serious matter requiring further consideration. It did not vary significantly in any country except Sweden, where the percentage of public procurement that was published increased from 20 % to 26 %, continuing an impressive trend in that country.

Another indicator of market transparency gives additional reason for concern. The number of invitations to tender that were published in the Official Journal have increased in recent years, but the number of contract award notices that were published did not increase proportionately. Market transparency is being reduced because relatively fewer details are known about the results of procurement competitions. This continues a recent trend of a growing gap between these two figures (see figure 16).

Finally, the number of award notices that indicate cross-border procurement remains very low. Direct cross-border procurement accounted for just 1.26 % of award notices in 2001 (1.5 % in 2000). This figure does not capture indirect procurement through affiliates in foreign countries, so the real level of cross-border procurement is greater than the figures suggest. Nonetheless, direct cross-border procurement is abysmally low and has not increased in recent years.

The application of public procurement directives has been accompanied by a high rate of infringements

The compared evolution of public procurement activities and the number of infringements related to public procurement gives further reasons for concern. The increase in the number of procurement notices published in the Official Journal has been matched by the increase in the number of infringements related to public procurement in recent years, although the number of infringements seems to have peaked and started to decline in 2000 (see figure 17 and its footnote). Unlike the trends in trade and foreign direct investment, increased transparency in public procurement has resulted in more "friction" in the application of procurement rules.

Thus, the few indicators available of the evolution of public procurement give us no reason to be optimistic.

This provides additional justification for speeding up the transition towards the new procurement directives. The new legislative package should improve this situation. It consolidates existing directives, streamlines awarding procedures and encourages the introduction of electronic technologies in public procurement.

After the introduction of amendments proposed by the European Parliament, the package is currently under discussion at the Council where a political agreement is expected. Besides the new legislative package, other ancillary measures could also improve performance in procurement markets (see box 4).

e-procurement could facilitate cross-border procurement

The Lisbon European Council conclusions called for progress in introducing e-government by the end of 2003. The introduction of fully fledged electronic procurement should make the procurement process run more smoothly, significantly decreasing transaction costs, as well as improving efficiency. There is evidence in Cardiff national reports that Member States are making efforts to incorporate these new technologies. This should contribute to increase transparency and open up to competition public procurement markets to domestic as well as foreign firms.

After recent and significant steps taken ("political agreement"), the adoption and swift implementation of the new legislative package is urgent now. Extended use of e-procurement and other ancillary initiatives could pay significant economic benefits as well. Finally, better monitoring of procurement, especially with respect to cross-border procurement, is needed.

Financial service markets

With the physical introduction of the Euro, both retail and wholesale financial markets within the eurozone use one currency but unfortunately do not form one unified market. Many obstacles remain...

...and not all of them can be removed by regulatory action. With the exception of the unsecured money markets of the eurozone, EU wholesale financial markets still exhibit varying degrees of fragmentation (see box 6). The Financial Services Action Plan (FSAP), the Commission's main instrument for realising a single market in financial services, has addressed some of the major obstacles.

A higher degree of integration has been reached in areas where a common market infrastructure has been put in place and/or where regulation has been adapted, but there is still some way to go in removing obstacles even in the wholesale markets...

In the unsecured money markets, full integration has been reached among the eurozone Member States. Harmonisation in this market segment includes the good traded (the single currency), the rules applying to it (the common monetary policy) as well as the trading infrastructure (TARGET).

Indicators confirm that full integration has been reached. Since January 1999, there has been full convergence of interest rates in this market and cross-border activity represents at least 60% of total activity.

Convergence of interest rates has occurred in the government bond market but is not as complete as it is in the unsecured money market (see figures 18 and 19). Some degree of fragmentation remains because of the different issuers: the different levels of liquidity and creditor quality explain the remaining spreads in interest rates. However, cross-border activity is clearly present in this market segment.

In other long (corporate bond market, equity markets) and short term (secured money markets) wholesale markets, involving an exchange of liquidity for paper, many obstacles to integration remain that are linked to collateral use, clearing and settlement, accounting practices, requirements for prospectuses, etc. Even though these difficulties have not prevented cross-border activity from developing, there is substantial room for further integration in these markets.

Recently adopted FSAP measures and others still in the pipeline address these problems....

The collateral directive [20], is set to tackle problems related to the acceptance of the different types of collateral used throughout Europe. Once operational, the directive should stimulate intra EU cross-border activity by improving legal certainty in the use of collateral.

[20] Approved by the EP on 15 May 2002. The implementation is scheduled for the end of 2003.

The costs for cross-border intra EU settlement are still much higher than for domestic transactions, which are similar to US levels. Reducing costs for cross-border intra-EU transactions to the level of domestic ones, would yield an estimated cost savings of 42% [21], i. e. EUR 693 millions (see box 7). The Commission has recently launched a survey to determine whether regulatory action is needed to reduce costs or whether markets will eventually bring about these changes by themselves [22].

[21] IVIE Report (forthcoming) for the EU Commission.

[22] The recent Euroclear-Crestco merger, effectively integrating 60% of EU settlement systems, is expected to reduce settlement costs considerably.

Events in the financial markets over the past year have once more demonstrated how essential it is to have reliable information, especially in times of economic uncertainty. If investors cannot rely on the accuracy of the information they are given, they will shy away from anything other than government bonds. In the aftermath of the accounting scandals in the US that led to the failure of large companies like Enron and WorldCom, investors have grown wary of corporate linked securities, leading to contractions in the sizes of the corporate bond market, stock exchange capitalisation and the commercial paper market. This has negatively impacted pension funds, insurance companies, banks' balance sheets and venture capital funds (where the impact will most likely be felt at the end of 2002) (see box 8).

The FSAP includes several measures to make financial information more reliable and comparable across countries. For instance, the draft prospectus directive [COM(2002) 460] will provide investor protection because prospectuses will be approved across the Union only if they meet common EU standards for what information must be disclosed and how. Firms will also benefit from cheaper and easier access to capital throughout the EU through simplifying the requirements for issuing a public offer prospectus. With respect to corporate accounting information, the implementation of the IAS for listed companies by 2005 will harmonise the way corporate accounts are presented and provide investors with clearer and more comparable information. Extending IAS to unlisted companies could stimulate cross-border intra EU venture capital investment as investors will be able to make better comparisons between their investment options (see box 8).

The least integrated of all financial markets are the retail markets.

Tax differences, the lack of harmonised financial products and information, structural and regulatory national differences and the local character of the relationship between customers and financial intermediaries are among the main barriers to more cross-border activity by European citizens and SMEs. This also applies to consumer and mortgage loans and also to private pension schemes and insurance policies.

The evidence available shows virtually no convergence of interest rates on consumer loans (see figure 22). The perceived convergence of mortgage rates (see figure 23) is not resulting from intensified competition but more because of convergence in money market rates (see box 9). As a result, no significant cross-border activity is reported in these markets.

Because of the "size and number" of customers in these market segments, market-driven changes do not come about as fast as in the wholesale market. The physical introduction of the Euro and the December 2001 Regulation on cross-border retail payments could accelerate integration. The introduction of the Euro has enhanced the transparency and comparability of products. The December 2001 regulation sets domestic and cross-border payments at the same level, starting July 2002 for electronic payments and July 2003 for cross-border bank transfers.

Other regulatory measures are being taken to help create an EU-wide financial market for retail customers

- The Commission proposal for a revised consumer credit directive aims at full harmonisation of rules applicable to all consumer credit (except home loans) [23].

[23] To improve transparency and comparability of credit cost, the proposal includes an obligation to provide information covering three types of costs: the borrowing rate, which provides full transparency on. the cost of the interest to be paid; the "total lending rate" which adds the overheads to be paid to the lender and thus provides clear comparability of lender offers among suppliers and across borders; and the Annual Percentage Rate, APR i.e. the total cost of credit to the consumer.

- Eighteen months after the Commission proposal, an agreement of principle has been reached regarding the directive on supplementary pension funds, which would allow for the cross-border provision of pension schemes while providing sufficient security to subscribers. Once adopted, this proposal should allow for further development of the pension fund market in Europe and contribute to the mobility of workers.

- The Insurance Mediation Directive [24] aims at improving consumer choice and protection while helping insurance intermediaries market their services across borders. The directive will come into force in late 2004.

[24] Approved by the Council of Ministers on 30 September 2002.

Even though many of the identified regulatory obstacles to more integrated markets are being addressed by the FSAP, there is a clear need for faster implementation of regulation and its adaptation to the changing environment.

Delaying the introduction of these reforms implies a high cost for European citizens and firms.

- Providing EU companies with the same access to finance as US companies has been estimated to boost value added growth in a range of industrial sectors [25] by an enduring 0.74-0.92 percentage points (see box 5).

[25] CEPR study for DG Economic and Financial Affairs available at http://europa.eu.int/comm/economy_finance/publications/economic_papers/economicpapers179_en.htm

- The one off macro-economic impact of pooling liquidity in European equity and corporate bond markets [26] has been calculated at 1.1 % of EU GDP (or EUR 130 billion in 2002 prices) over the long run, with gains in terms of employment, consumption and investment at 0.5 %, 0.8 % and 6.0 % respectively. Even when taking into account the current doldrums of the equity markets, this conclusion is not substantially altered (box 5).

[26] London Economics study for DG Internal Market available at

- A study commissioned by the EFR [27] suggests that the potential for higher growth through financial integration could be 0.5 % of annual EU GDP, or EUR 43 billion a year.

[27] EFR: European Financial Services Round table.

- The European financial structure is still predominantly bank-based. Dependence on bank finance is even higher for unlisted SMEs without an external rating. Data shows that the own funds/total assets ratio of EU SMEs is on average much lower than of their US counterparts (see tables d and e in box 9). Estimates show that a 10% drop in bank-based financing in favour of capital market financing would mean a reduction in financing cost equivalent to 0.3 % of EU GDP [28].

[28] IVIE forthcoming.

- The benefits from eliminating the inefficiencies of some market segments are substantial as well. In the EU banking sector alone, these inefficiencies are estimated to total between 1.4 and 1.6 % of GDP [29].

[29] IVIE forthcoming.

V. Summary and conclusions

This report shows that there is potential for future integration, points out some countries and economic sectors where that potential is greater and presents estimates of potential benefits from several economic reforms that the European economy has been awaiting for the past four years. In many cases, especially in the financial services sector, they are of the same order of magnitude as the Union's entire economic growth for the past year. This is important for policy making and priority setting purposes now when the competitiveness gap with the USA is widening and labour productivity still grows more than twice as fast in the US as it does in Europe [30].

[30] See SEC(2002) 528 "2002 European Competitiveness report".

It is not just a matter of missing "potential benefits". Every additional year of delay in the implementation of these economic reforms is costing European citizens money now. This report demonstrates that the rate at which some of these reforms are being implemented is roughly equivalent to the rate at which prior Internal Market legislation has been implemented during the last decade, showing that decision-makers apparently feel no sense of urgency. This is not good enough.

The commitment to competitiveness made by the Heads of State and Government in Lisbon in March 2000 and renewed in Barcelona calls for more rapid action. We can no longer delay the adoption of pending proposals.

The report has also reinforced the conclusion of successive European Councils that a key obstacle to the implementation of structural reforms, that have been agreed to at EU level, has been late transposition. We can no longer afford these delays in the crucial stage of transposition, especially in the implementation of economic reforms included in the Lisbon strategy.

A formal declaration by Member States to transpose and implement structural reform measures within the legal allowed timeframes (i.e., without incurring lengthy and costly additional delays) would be a credible message of their commitment to the reform process. In addition, each country could reinforce the credibility of this commitment by voluntarily defining their deadlines and quantitative objectives. Each Member State could also pay more attention to following up judgements of the European Court of Justice affecting the Internal Market and ensuring that the necessary amendments are made to national law. This process could accelerate the implementation of reforms, thereby benefiting citizens.

The creation of a real Internal Market for services is perhaps the most important mid and longer term goal. The objectives of the Lisbon European Council are not achievable without an Internal Market for services. In addition, some of the benefits from the creation of the Internal Market are being squandered now due to the poor performance of the services sector in Europe. As shown in the Commission report on barriers to integration in services and in the annex to this report, lack of integration in the services sector is depriving the EU economy of substantial current and future benefits. Independent action by Member States is necessary but not sufficient for making significant progress. Only the implementation of the services strategy can effectively contribute to accomplishing this goal at the EU level.

Completing work in the financial services sector is the most urgent objective. We have seen that legislation in this area has been especially difficult to implement.

Consumers in particular ultimately pay the price for the existence on Internal Market barriers. Thus consumers cannot benefit from a variety of competitively priced goods and services and the better quality of life they might expect.

Public procurement is the third area calling for the speedy implementation of reforms. New measures to open up public procurement are in motion, but implementing these measures will take time. This is an additional reason to prioritise these reforms. More and better indicators of public procurement markets would help to better assess their true performance and any progress that has been made in integrating them.

Finally, the significant efforts expended on reducing the regulatory burden on SMEs and start-ups should be complemented with the full and effective implementation of the action plan for better and simpler regulation. In this regard, additional efforts are needed to integrate the "Internal Market" dimension as pointed out in the annex to this report. National administrations need to take into consideration not just the impact of regulations and legislation on domestic economic actors but also on other EU actors operating within the Internal Market.

All these reforms should come to complement reforms already underway in markets providing services of general interest. Recent developments in these markets are presented in a special annex to this report. It shows that economic reform is making progress in energy sectors although obstacles to market opening remain and the effects of these obstacles are felt on price levels, particularly for households and small commercial users. The situation should be greatly improved with the adoption of the energy package currently under discussion, especially after the agreements at the Barcelona European Council to open markets to commercial users in 2004 and the recent political agreement to open them to households in 2007. As a result of reforms in postal services, significant quality improvements are reported at Community level. Telecommunications services continue rendering dividends and this is reflected by increased consumer satisfaction especially with mobile telephony. The situation in transport sectors requires attention. The transposition and implementation of the rail infrastructure package directives by 15.3.2003 should help improve performance in this market.