Communication from the Commission - The euro area in the world economy - developments in the first three years
Date: 2002-06-19
Institutions: European Commission
Subjects: Economic and Monetary Union, balance sheet, economic situation, euro, euro area, free movement of capital, international currency, investment, pay, world economy

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 19.6.2002
COM(2002) 332 final

COMMUNICATION FROM THE COMMISSION

The euro area in the world economy
– developments in the first three years –

   
COMMUNICATION FROM THE COMMISSION

TABLE OF CONTENTS

EXECUTIVE SUMMARY...................................................................................................... 3

1.

1.1

1.2

1.3

1.4

2.

2.1

2.2

2.3

3.

3.1.

3.2

4

4.1

4.2

4.3

4.4

4.5

4.6

4.7

5.

5.1

5.2

5.3

5.4

5.5

ECONOMIC SITUATION AND POLICY ACHIEVEMENTS................................................. 8

The third year of the single currency: Coping with the global slowdown ................... 8

The euro exchange rate and the external accounts..................................................... 10

Economic policies in the euro area ............................................................................ 12

Coordination of economic policies in EMU .............................................................. 15

MONITORING WAGE DEVELOPMENTS IN EMU ........................................................ 17

Introduction................................................................................................................ 17

Aggregate wage developments: some stylised facts .................................................. 18

Factors behind the wage moderation observed in recent years.................................. 20

INVESTMENT AND THE EURO AREA GROWTH POTENTIAL ........................................ 23

Investment trends in the euro area in the 1990s......................................................... 23

Determinants of investment in the euro area.............................................................. 25

THE EURO AREA FINANCIAL SYSTEM ........................................................................ 28

Overall developments in the EU financial system ..................................................... 28

Money and derivatives markets ................................................................................. 29

Bond markets ............................................................................................................. 30

Equity markets ........................................................................................................... 32

Venture capital ........................................................................................................... 34

Financial intermediaries ............................................................................................. 34

Challenges for policy makers..................................................................................... 35

THE EURO AS AN INTERNATIONAL CURRENCY.......................................................... 37

Introduction................................................................................................................ 37

The international use of the euro by the private sector .............................................. 37

International use of the euro by the official sector..................................................... 39

The candidate countries and adoption of the euro ..................................................... 40

The euro area’s contribution to global policy coordination ....................................... 41

2

The euro area in the world economy – executive summary

Stage Three of Economic and Monetary Union (EMU) started on 1 January 1999 with the 11 Member
States which had achieved a high degree  of  nominal  convergence,  as  mapped  out in the  EC Treaty.
Greece was subsequently judged to have met the conditions for successful participation too, and joined
the others on 1 January 2001. The introduction of notes and coins on 1 January 2002 was a difficult
logistical exercise, but proceeded as smoothly as anybody could have hoped. The euro has become a
tangible reality.

The benefits of the single currency, anchored in a sound institutional policy framework of responsible
macro policies, and combined with structural reform, have been visible in the first three years of Stage
Three of EMU. During the first two years, GDP grew at some 3 %, somewhat above potential, without
creating the kind of imbalances that threaten the sustainability of growth in many parts of the world.
Private  savings  have  remained  at  a  satisfactory  level  of  about  15%  of  disposable  income,  budget
deficits  have  continued  to  decline,  albeit  not  at  the  same  pace  as  during  the  1990-98  convergence
phase, increasing net public savings, and investment has been healthy, but steady, without creating an
over-investment  problem.  As  a  result,  the  current  account  of  the  euro  area  has  remained  roughly  in
balance.

The third year of the single currency : Coping with the global slowdown

In 2001, the global economy cooled down very rapidly, and world trade declined from a growth rate of
some 12% in the preceding year to almost no growth at all. Even though the euro area is a significantly
closer economic entity than its constituent Member States, trade remains important, so the appreciable
decline  in  global  trade  was  bound  to  have  a  significant  impact.  In  addition,  the  euro  area  is  highly
integrated into the global economy, so the effects of international developments are also reflected in
financial links, cross-border company ownership, and confidence. Common shocks, the increase in oil
prices,  the  September  11th,  and  a  correction  in  stock  prices  have  all  contributed  to  the  global
slowdown.  But  domestic  factors  have  also  played  a  part.  GDP  growth    in  the  euro  area  decelerated
during the year, and came to a virtual standstill in the final quarter of 2001.

Despite  the  slowdown  in  activity,  employment  creation  held  up  surprisingly  well,  arguably  a
beneficial  result  of  labour  market  reforms,  carried  out  in  preparation  for  the  single  currency  and
continued since. In the first three years of the single currency some 6 million jobs have been created in
the euro area. On a slightly less positive note, inflation has increased from its very subdued level of
just over 1% in the first year of Stage Three of EMU to a level of 2 ½% in 2001. This is mainly the
result of a succession of special factors: two oil price hikes, the effect of which was compounded by
the weakness of the euro against the currencies of major trading partners, and a series of disease and
weather-related increases in food prices.

The euro exchange rate and external performance

Following  its  launch in  1999,  the  euro  depreciated  by  more  than  20%  against  the  USD.  In  nominal
terms it had effectively lost more than 10% by spring 2001, but has remained fairly stable since1. The
euro’s real exchange rate in terms of unit labour cost is far below its long-term (1980-2000) average.

1 

The cut-off date of this Communication was 21 March 2002.

3

                                                
As  a  result,  the  euro  area’s  producers  enjoy  a  favourable  position  when  competing  with  third
countries’ suppliers. The competitive edge of domestic production over foreign supply helps to explain
why net exports could make a positive contribution to GDP in 2001, despite the sharp decline in world
trade. At the same time the failure of the euro to appreciate towards a level more in line with economic
fundamentals, was of little help in containing inflation.

From  a  global  point  of  view  there  are  still  substantial  external  imbalances.  A  large  current  account
deficit the US economy is matched by a large current account surplus in Japan and some other Asian
countries,  while  the  euro  area  as  a  whole  registered  a  current  account  close  to  balance.  How  far
cyclical  factors  contribute  to  global  imbalances  is  open  to  question,  but  they  should  unwind  as
economic growth in the respective areas returns to trend.

Fiscal and monetary policies

Starting from an unbalanced budgetary situation, the last six years have seen a great deal of progress
towards achieving greater fiscal consolidation. Since the beginning of 1999, fiscal policies have been
under of the Stability and Growth Pact (SGP) and have complied in full with the 3 % reference value.
“Fiscal  adjustment  has  continued  in  a  majority  of  countries,  although  it  is  slowing  down.  Tax  cuts
already decided upon and the cyclical slowdown in 2001 have widened actual budget deficits, but the
structural  deficits  have  remained  broadly  unchanged.  Automatic  stabilisers  have  been  allowed  to
cushion the effects of the slowdown in most Member States.

Notwithstanding  the  progress  made,  there  are  still  appreciable  budget  deficits  in  Germany,  France,
Italy  and  Portugal.  Further  consolidation  efforts  are  necessary  to  reach  positions  that  are  close  to
balance  in  2004.  Commitments  to  this  end  were  made  in  the  2001  round  of  updated  stability
programmes.  Member  States’  commitment  to  this  medium-term  target  were    confirmed  by  the
European Council in Barcelona. As a result of the  discussion  in  Council on  the  Commission’s  draft
recommendations for an early warning, Germany and Portugal gave firm political commitments which
responded to the substance of the Commissions concerns.

Monetary  policy  has  continued  to  focus  on  its  primary  objective  of  price  stability  in  the  euro  area,
defined by the ECB as an HICP inflation rate of below 2%, to be achieved in the medium run. The
forward-looking, medium-run orientation of the ECB allowed interest rates to be lowered four times in
2001  by  a  cumulative  150  basis  points  to  a  level  of  3¼  %,  against  the  background  of  a  slowing
economy  exerting  downward  pressure  on  inflation.  Financing  conditions  have  continued  to  be
conducive  to  growth.  At  the  same  time,  inflation  expectations  have  remained  compatible  with  the
ECB’s  quantitative  definition  of  price  stability.  As  inflation  rates  continue  to  differ  across  Member
States,  and  monetary  conditions  tend  to  be  too  tight  where  inflationary  pressures  are  low,  and  too
accommodative  where  final  demand  exceeds  potential  output.  Fiscal  policy  can  be  one  possible
instrument, but could become overburdened without a more flexible wage and price system.

Policy coordination

A  sound  economic  policy  framework  has  prevailed  during  the  first  three  years  of  EMU.  It  is
characterised  by  a  number  of  principles  enshrined  in  the  Treaty  -  commitment  to  an  open  market
economy  with  free  competition,  stable  prices  and  sound  public  finances  -,  which  are  conducive  to
sustainable growth and high employment. The single monetary policy is entrusted to the independent
ECB.  Its primary objective  is to  maintain  price  stability.  Responsibility  for  most economic  policies,

4

i.e. national budgetary policy and structural policies, remains with the Member States.

The  Treaty  provides  for  a  system  of  economic  policies’  coordination,  fostering  positive  spill-over
effects and taking into account possible negative externalities that could occur when decision-making
is not coordinated. The Broad Economic Policy Guidelines of the Member States and the Community
(BEPGs) are the central element in this system. The vigorous job creation witnessed since 1997 also
reflects  the  labour  market  reforms  undertaken  by  Member  States,  inter  alia  in  the  context  of  the
European Employment Strategy. The annual Employment Guidelines are the Treaty-based instrument
for employment policy coordination. Another important element, based on the Treaty, is multilateral
surveillance of economic policies.

Strengthened  economic  (i.e.  fiscal  and  structural)  policy  coordination  could  be  improved  by
streamlining  processes  where  appropriate  and  by  implementing  the  measures  suggested  by  the
Commission and endorsed by the Barcelona European Council. For better common assessment of the
economic  situation,  there  needs  to  be  more  work  on  EMU  statistical  requirements.  And  for  more
universal understanding of what constitute good economic policies in EMU, the Commission intends
to  propose  a  set  of  common  standards  for  the  conduct  of  economic  policies  to  help  achieve  more
consensus, better economic governance, and increase transparency.

Wage formation under EMU

Monetary  Union  has  in  many  ways  changed  the  macro-economic  environment  for  wage  and  price
setting  in the  euro  area.  Wage  bargaining  needs  to  be  adapted  to  the  new  policy  framework,  which
requires  a  higher  degree  of  nominal  wage  flexibility  in  order  to  guarantee  the  euro  area
competitiveness. At the same time, wage increases at the national level need to take into account the
impact on area wide inflation.

In the euro area as a whole the last decade has seen impressive progress on nominal stabilisation of
both  prices  and  wages.  Indeed,  the  1990s  saw  a  remarkable  disinflation  process,  and    by  1997  the
inflation  rate  had  fallen  below  the  2%  mark.  Despite  an  increase  in  2001,  nominal  unit  labour  cost
inflation in the euro area has fallen rapidly. Moreover, despite a marked reduction in unemployment
over  the  past  few  years,  there  have  been  few  signs  of  a  significant  re-acceleration  of  nominal  unit
labour  cost  growth.  All  in all, there  can  be little  doubt  that in the  early  years  of  EMU,  and even  in
some of the preceding years, there was an impressive amount of nominal wage moderation, which is
difficult to attribute to anything other than changes in underlying behavioural relations.

Real wage moderation has borne fruit and contributed to the dynamism in job creation in recent years.
Estimates  indicate  that  the  NAIRU  for  the  euro  area  has  fallen  by  about  1½percentage  points,
suggesting that about half of the improvement in actual unemployment can be considered structural in
nature.  The  wage  discipline  reflected  in  the  fall  of  the  NAIRU  is  explained  by  the  relatively
widespread product and labour market reforms in most euro area countries, which spurred competition
in goods and services markets and tackled insider-outsider divisions in the labour markets during the
second half of the 1990s.

However,  it  must  also  be  acknowledged  that  progress  on  reform  has  been  fairly  uneven  across
countries,  with  all  the  major  economies  of  the  euro  area  still  plagued  by  relatively  high  structural
unemployment. Reforms have also been rather piecemeal, suggesting that further reforms are needed
if the fall in the NAIRU is to continue.

5

Thus, it is difficult to explain this widespread wage moderation without considering the role of income
policies  in  a  number  of  countries.  The  task  is  to  reconcile  the  need  for  area-wide  wages  to  remain
compatible  with  the  ECB  price  stability  objective  with  the  need  for  more  flexibility,  reflecting
differences  in  the  level  and  growth  rates  of  productivity,  so  as  to  react  appropriately  to  changes  in
demand specific to regions or sectors and improve prospects for profitable jobs.

Investment and growth potential in the euro area

Public and private Investment are crucial for the development of the euro area’s growth potential in
the  medium  and  longer  term.  EMU  and  the  policy  framework  in  which  it  is  embedded  is  likely  to
positively affect major determinants of investment such as profitability and real interest rates: greater
financial  integration  will  improve  financing  conditions  and  reduced  exchanges  rate  risks  will  allow
investment to be allocated more efficiently. Finally, with fiscal discipline there will be less crowding
out of private investment.

It  is  too  early  to  reach  definite  conclusions  on  the  impact  of  EMU  on  investment  given  the  time
elapsed  since  the  introduction  of  the  euro.  Nevertheless,  some  encouraging  signs  point  in  the  right
direction. If one includes the  run-up  to  EMU  since the  mid-1990s,  real interest rates as  well as real
exchange rate variation have declined and post-tax profitability is sustained at a relatively high level.
Equally,  the  economies  of  the  euro  area  show  considerable  convergence  of  investment  rates,
accompanied by convergence of economic conditions such as profitability and interest rates, which are
the  result  of  both  deeper  market  integration  and  a  more  harmonised  institutional  framework.  The
evidence  from  FDI  flows  is  less  conclusive.  M&A  activities,  perhaps  reflecting  the  longer-term
strategic objectives of companies have dominated FDI flows in recent years.

The euro and the euro area financial system

The pace of integration of euro area financial markets has clearly accelerated since the changeover to
the  euro  in  January  1999.  Of  course  the  euro  is  not  the  only  factor  behind  this  acceleration:
globalisation, fostered by the liberalisation of international capital movements, financial deregulation
and advances in technology, and progress in creating a common regulatory framework across the EU
(as part of the effort to complete the internal market in financial services) have also been crucial, as
have the financial reforms undertaken at Member State level.

The euro has eliminated exchange risk as a source of fragmentation in the euro area financial system
and at the same time it has fully exposed the opportunity costs of the remaining barriers to integration.
Deeper integration due to the euro is reflected in more homogenous markets, a wave of consolidation
among  intermediaries  and  exchanges  and  the  emergence  of  new  and  innovative  products  and
techniques.

As  market  operators  have  adopted  more  pan-European  strategies,  policymakers  at  EU  level  have
responded  by  elaborating  a  coherent  policy  strategy  for  the  completion  of  the  internal  market  for
financial  services  and  committing  themselves  to  its  rapid  implementation  (see,  for  instance,  the
Conclusions of the Barcelona European Council in March 2002). First, and most importantly, the EU
has set an ambitious deadline, the year 2005, for the implementation of the Financial Services Action
Plan  (FSAP)  -  a  package  of  42  policy  initiatives  aimed  at  improving  the  functioning  of  the  EU
financial system. An even tighter deadline, 2003, has been set for actions relating to securities markets
and for the Risk Capital Action Plan (RCAP). The latter is the blueprint for developing an integrated

6

and efficient market for equity financing of young and innovative businesses. Second, implementation
of the FSAP is to be consistent across all of the Member States so that there is effective – rather than
just  nominal  -  integration  of  national  financial  markets.  The  new  decision-making  framework  for
securities  legislation,  adopted  on  the  basis  of  the  proposals  by  the  Lamfalussy  Committee  should
contribute to this objective and ensure that legislation is more swiftly adapted to the evolving financial
markets. Third, competition policy is to be pro-active as financial integration proceeds, so as to ensure
that  economic  benefits  are  fully  exploited.  Fourth,  consumers  and  investors  are  to  be  adequately
protected so that they have the confidence to operate in - and so enjoy the full benefits of – a single
market extending across the Union.

The euro as an international currency

The US dollar is still the main international currency, but the euro became the world's second leading
currency after its launch. There are a number of factors that support use of the euro as an international
currency. The first is the large size of the euro-area economy. It accounts for approximately 16% of
world GDP, making it somewhat smaller than the US (21%), but much larger than Japan (8%). Figures
for the share of the three areas of total world trade in goods and services are similar. The second factor
which makes the euro attractive as an international currency is its stability, which reflects the sound
economic  fundamentals  of  the  euro  area,  underpinned  by  the  stability-oriented  economic-policy
framework  under  EMU.  The  third  factor  is  the  ongoing  integration  of  national  financial  markets  in
Europe into broad, deep and liquid pan-European financial markets, which will enhance the role of the
euro  in  international  borrowing  and  lending  activity.  Nevertheless,  because  of  network  and  scale
effects the US dollar is likely to remain the dominant currency. In any event, internationalisation of the
euro is a process driven by the private sector, and the Eurosystem neither hinders nor actively promote
internationalisation of the euro as a policy objective.

The  euro  area, and  no longer its  Member  States, are  now  considered  by  the rest  of  the  world  when
international macro-economic issues are discussed. International institutions in charge of multilateral
surveillance, such as the IMF and the OECD, have started to acknowledge the implications of these
changes  by  assessing  on  a  regular  basis  the  overall  macro-economic  stance  of  the  euro  area.  The
change  is  also  reflected  in  G7  Finance  Ministers’  statements  that  no  longer  refer  to  the  macro-
economic stance of specific euro area Member States but to the overall euro area position.

EMU has fostered, a process to develop common European positions, allowing the Community to start
playing an international role commensurate with its financial and economic weight. This needs to be
complemented by further progress on representation.

7

1.

1.1

ECONOMIC SITUATION AND POLICY ACHIEVEMENTS

The third year of the single currency: Coping with the global slowdown

In the first two years of Stage Three of EMU, GDP grew above potential, averaging 3% per annum,
followed by a sharp but short-lived downturn in the third year. In 2001, GDP growth decelerated, and
is likely to remain subdued in the first part of 2002. There were domestic and external reasons for the
slowdown.  Private  consumption  has  been  sluggish  since  Autumn  2000,  as  the  purchasing  power  of
euro area households was weakened by the surge in energy and food prices as well as the appreciation
of  the  US  dollar  against  the  euro.  In  addition,  consumer  confidence  deteriorated  with  increased
uncertainties  about  income  prospects  and  falling  stock  prices.  Investment  contracted  as  profits
declined, and demand prospects deteriorated.

Real GDP growth : Euro area, US and Japan

Euro area

US

Jap

YoY %

4

5

There  has  been  increasing  synchronisation
with  the  global  economy.  Since  the  start  of
the  single  currency,  the  euro  area  GDP
growth  rate  has  narrowed  the  gap  with  the
US,  while  at  the  same  time  the  cyclical
pattern has become highly synchronised with
other  major  economies.  This  contrasts  with
the  convergence  period  (1990-98).  The  high
degree  of  synchronisation  during  last  years
recession  was  explained  by  common  shocks
–  the  hike  in  oil  prices,  the  burst  of  the  IT
bubble,  and the  September  11  events.  But  it
can  also  be  seen  as  a  sign  that  the  euro  has
started to behave more like one would expect
is  as  deeply
from  an  economy  which 
integrated into the global economy as the euro area.

-1

0

1

2

3

1988-92

1993-98

1999

2000

2001

On the external side, foreign demand plunged,
because of the sharp decline in global activity.
World  trade  growth  had  steeply  decelerated
and despite the weak euro, real export growth
from the euro area dropped sharply from 12½
%  in  2000  to  slightly  above  2%  last  year.
Nevertheless, as imports contracted at a faster
pace  than  exports,  the  external  sector  made  a
positive  contribution  to  growth.  Recovery  of
improving
activity  might  be  driven  by 
consumer  confidence,  accompanied  by  gains
in 
depleted
income, 
inventories, 
growth-supportive  monetary
conditions,  and  a  more  favourable  external
environment.

disposable 

real 

Euro area export

11.4

11.7

9.9

7.6

Asian crisis
5.2

synchronised
slowdown

1.3

14

12

10

8

6

4

2

0

1996

1997

1998

1999

2000

2001

Source: Commission, DG ECFIN

8

(in millions)

Job creation

Euro area

US

The acceleration in economic activity during the
first  two  years  had  a  beneficial  impact  on
employment. But interestingly job creation held
up reasonably well, even during the downswing.
In  the  first  three  years  of  the  single  currency
some  6 million  jobs  have  been  created  in  the
euro area as against 3.5 millions in the US. The
unemployment  rate  decreased  from  11.3%  in
1997  to  8.3%  in  2001.  Thus  GDP  growth  has
translated into higher employment growth.

3

2

1

0

The  explanations for  this  job-rich  growth  lie  in
structural  changes  in  the  labour  market.  A
protracted  period  of  wage  moderation  has
reversed the capital-labour substitution trend that was detrimental to  employment  in  the  first  part  of
the  90s.  On  the  supply  side  the  participation  rate  of  women  in  particular  has  increased  appreciably
along  with  the  share  of  part-time  jobs  and  temporary  contracts  in  total  employment.  Average
participation rates are nevertheless still below those of the US or Scandinavian countries.

1997

1996

1999

2000

1998

-1

2001

Productivity  growth  in  the  euro area  and  in  the
US  was  roughly  equal  on  average  during  the
first  half  of  the  1990s.  However,  since  the
second half of the 1990s productivity in the US
has been significantly stronger than usual at the
mature  state  of  the  cycle,  while  productivity  in
the  euro  area  has  maintained  a  more
conventional  pace  and  pro-cyclical  pattern.
Another major difference has been stronger  US
labour  supply  growth,  to  some  extent  due  to
migration, and the ability of the US economy to
absorb  a  growing  work  force.  Both  factors
explain why GDP growth has been higher in the
US than in the euro area.

increases 

Following very subdued inflation at the start  of
Stage  Three  of  EMU,  since  the  beginning  of
in  consumer  prices  have
2000, 
remained  above  the  ECB’s  2%  threshold.  The
headline HICP inflation rate increased from just
1.1%  in  1999,  to  2.3%  in  2000  and  2.5%  in
2001.  The  increase  can  be  explained  to  a  large
extent  by  a  succession  of  special  cost  push
factors,  while  the  output  gap  has  been  mostly
negative since the mid-1990s.

Productivity growth - GDP per person em ployed

EA

US

0

0.005

0.01

0.015

0.02

0.025

Headline  and core  HICP inflation in the e uro area
Annual percentage changes; monthly data

headline HICP

core HICP* 

2001

2000

1999

1990-98

3.5

3

2.5

2

1.5

1

0.5

0
Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

*core inflation is HICP excluding energy and unprocessed food  Source: Eurostat

9

Two  main  cost-push  factors  have  dominated  developments  in  consumer  price  inflation:  surges  in
import prices and domestic food prices. Higher import prices, mainly a combination of higher world
oil prices and a weaker euro, were the main driving force behind the rise in inflation during 1999 and
most  of  2000.  By  the  end  of  2000,  the  BSE  scare,  the  foot-and-mouth  outbreak,  and  unusually  bad
weather had taken over and were helping to keep HICP inflation accelerating until mid-spring 2001.
Finally,  as  2002  began,  further  rises  in  fresh  food  prices,  owing  to  unusually  cold  weather  in  some
parts  of  Europe,  as  well  as  less  favourable  developments  in  energy  prices,  again  pushed  headline
inflation in the upward direction.

1.2

The euro exchange rate and the external accounts

Euro area

Following  its  launch  in  1999,  the  euro  depreciated  by  more  than  20%  against  the  USD,  but  has
regained some 10% from its low point in October 2000. In nominal effective terms it had lost more
than 10% by spring 2001, but has remained fairly stable since. The more recent stability is a result of
the USD and the GBP fluctuating without clear direction in a broader range vis-à-vis the euro, while
the  depreciation  of  the  euro  against  the  CHF  was  broadly  offset  by  gains  against  JPY.  The  relative
stability of the effective exchange rate over this period is surprising, given the dramatic swings which
have  taken  place  in  the  world  economy,  and  the  general  perception  that  the  euro  is  fundamentally
undervalued.

Bilateral exchange rate

Real effective exchange rate

1.4

1.2

1

0.8

Yen

USD

9
9
-
n
a
J

9
9
-
y
a
M

9
9
-
p
e
S

0
0
-
n
a
J

0
0
-
y
a
M

0
0
-
p
e
S

1
0
-
n
a
J

1
0
-
y
a
M

1
0
-
p
e
S

2
0
-
n
a
J

2
0
-
y
a
M

140

120

100

80

130

120

110

100

90

80

70

unit labour cost, total economy
unit labour cost, manufacturing

1980-2000 = 100

4
9
-
n
a
J

4
9
-
l
u
J

5
9
-
n
a
J

5
9
-
l
u
J

6
9
-
n
a
J

6
9
-
l
u
J

7
9
-
n
a
J

7
9
-
l
u
J

8
9
-
n
a
J

8
9
-
l
u
J

9
9
-
n
a
J

9
9
-
l
u
J

0
0
-
n
a
J

0
0
-
l
u
J

1
0
-
n
a
J

1
0
-
l
u
J

2
0
-
n
a
J

The euro’s real effective exchange rate in terms of unit labour cost is far below its long-term (1980-
2000) average. The euro area’s producers have a favourable strong position in competing with third
country suppliers. The competitive edge of domestic production over foreign supply helps explaining
why net exports could make a positive contribution to GDP in 2001, despite the sharp decline in world
trade  .  At  the  same  time  the  failure  of  the  euro  to  appreciate  towards  a  level  more  in  line  with
economic fundamentals, was of little help in containing inflation.

The real effective exchange rate is a major determinant of cross-border trade flows. Changes in direct
taxes, wage settlements and country-specific cost factors influence the position of domestic producers
in  world  markets2.  A  real  depreciation  tends  to  improve  the  competitive  position  of  domestic
producers  but  at  the  same  time  means  a  loss  in  purchasing  power  for  consumers.  It  also  has  an
unfavourable  effect  on  inflationary  pressures.  Which  level  of  ‘competitiveness’  is  appropriate  will
depend on economic circumstances at the time.

The euro area current account continued to improve throughout 2001. The annual aggregate displayed

2 Price competitiveness is a narrow concept, other factors such as product quality, services and punctuality also
influence the strength of a country’s  export  sector.  The  World  Economic  Forum’s  Global  Competitiveness
Report  ranks  countries  by  their  ”current  competitiveness”  and  “growth  competitiveness”.  The  European
Commission also publishes a report every year on competitiveness of enterprises. See also “Competitiveness:
A Dangerous Obsession” by P. Krugman, Foreign Affairs, March-April 1994.

10

                                                
4

Current account balances 1999-2003
(in % o f GDP )

a very small surplus, and according to most recent forecasts it is expected to show a small surplus until
2003.  From  a  global  point  of  view  substantial  external  imbalances  remained  unabated.  The  large
current  account  deficit  of 
the  US
economy  is  partly  offset  by  a  large
current account surplus in Japan and some
other  countries  in  Asia,  while  the  euro
area  as  a  whole  registered  a  current
account close to balance. How far cyclical
factors contribute to global imbalances is
open to question, but they should unwind
as  economic  growth  in  the  respective
areas  returns  to  trend.  Ceteris  paribus,
imply  current
cyclical  factors  would 
account  deficits  in  periods  of  above-
average  income  growth  and  surpluses  in
times of below-average income growth.

Euro Area USA

Japan

2003*

2002*

* f orecast

1999

2000

2001

-4

-2

-6

0

2

Member States

2

6

4

8

Current account balances 1999-2001
(in % of  GDP)

While the euro area  current account has shown  no significant imbalance  during  its first three  years,
there  have  been  differences  in  developments  in  the  Member  States.  External  imbalances  within  the
euro area raise questions about the appropriateness and sustainability of external imbalances in EMU.
In  general,  although  there  have  always
been  current  account 
imbalances  at
Member  State  level  in  the  past,  the  euro
has significantly changed the situation as:
the single financial market makes it easier
to  finance  deficits.  Indeed,  countries
could run imbalances for a long time thus
accumulating large net external positions.
This is not inherently inappropriate. There
can  be  good  reasons  for  current  account
deficits  (e.g.  in  the  context  of  catching
up)  reflecting  private  sector  activity.
However,  an  imbalance  in  a  Member
State’s 
account  will
ultimately  imply  a  change  in  its  net  external  position.  And  even  without  discussing  the  theoretical
foundations  of  current  account  sustainability,  the  accumulation  of  external  debt  will  be  subject  to
ceilings,  at  some  level.  Because  corrections  can  no  longer  take  the  form  of  nominal  exchange  rate
changes, other channels affecting competitiveness have become more important. For a country, which
has to improve price competitiveness, wage moderation or structural reform to raise productivity are
the only means. Structural reform has become particularly urgent as relative wage moderation is more
difficult in the low-inflation environment of the euro area.

international 

I
2001

IRL
2000

D
1999

NL FIN 

EL

-12

-10

-4

-8

-2

-6

E

A

P

B

F

0

The competitiveness situation varies across Member States, both with respect to  level  and its  recent
developments. In the individual Member States the following developments have taken place since the
start of EMU compared with the euro area average3: in some, cost competitiveness declined - Portugal
(down  by  10%),  the  Netherlands  (-8%),  Ireland  (-6%)  and  Spain  (-3%)  others  improved  their  cost
competitiveness;  Germany  (up  by  +5%),  Greece  (+5%)  and  Austria  (+2%);  while  in  others  cost
competitiveness remained broadly stable: France (+0.6%), Belgium-Luxembourg (-0.4%), Italy (-1%)
and Finland (-1%).

3 As measured by the real effective exchange rate in terms of unit labour cost in manufacturing.

11

                                                
The trends observed since the beginning of the single currency do not necessarily indicate movements
away from the appropriate level of competitiveness, as the starting positions might not have reflected a
position  of  equilibrium.  Divergent  real  effective  exchange  rate  paths  in  the  Member  States  can  be
explained  in  terms  of  different  rates  of  productivity  growth,  different  inflation  rates,  and  structural
factors such as the openness of the economy and the composition of trade. So an in-depth assessment
of movements in real exchange rates requires a comprehensive analysis of the economic situation in
each country.

One way to assess the potential implications would be to look at the variation in export prices minus
the variation in unit cost in unit cost of manufacturing labour  as a  proxy  for  developments in  profit
margins. If cost increases can not be passed on to export prices, because producers have little pricing
power in their export markets, then profit margins will increasingly come under pressure. Taking the
three countries with the largest loss in competitiveness against the euro area as an example, Portugal
and the Netherlands have a similar geographical breakdown in external trade -, about 1/3 is with the
world  outside  the  euro  area  and  2/3  within  the  area  -,  while  for  Ireland  the  weight  is  55%  outside
versus 45% inside. This implies that Ireland’s loss within the euro area is less important and its gain
from the euro weakness larger than for the other two countries.

Real effective exchange rate against the euro area

Ireland

Netherlands

Portugal

105

100

95

90

wider profit margins

110

105

100

95

110

wider profit margins

105

100

95

Profit squeeze

9
9
-
n
a
J

9
9
-
l
u
J

0
0
-
n
a
J

0
0
-
l
u
J

1
0
-
n
a
J

1
0
-
l
u
J

2
0
-
n
a
J

2
0
-
l
u
J

9
9
-
n
a
J

9
9
-
l
u
J

0
0
-
n
a
J

0
0
-
l
u
J

1
0
-
n
a
J

1
0
-
l
u
J

2
0
-
n
a
J

2
0
-
l
u
J

9
9
-
n
a
J

9
9
-
l
u
J

0
0
-
n
a
J

0
0
-
l
u
J

1
0
-
n
a
J

1
0
-
l
u
J

2
0
-
n
a
J

2
0
-
l
u
J

unit labour cost, total economy

unit labour cost, manufacturing

Price deflator exports of goods/services

From a policy perspective, it is important to monitor Member State’s current account balances within
the  euro area  in  addition to  the  area-wide  balance,  as  they  may  give  indications  of  country  specific
problems.  Price  competitiveness  may  be  worsening  as  a  move  towards  or  away  from  equilibrium.
Monetary policy is oriented towards the euro area, and is therefore ineffective in dealing with country
specific excess demand or supply situations. Fiscal policy, and in particular structural reform, aimed at
increasing supply is needed to prevent external imbalances from accumulating, which might ultimately
threaten financial stability.

1.3

Macro economic policies in the euro area

Achievements

established 

As  regards  fiscal  policy,  the  Stability  and
Growth  Pact 
a
(SGP) 
comprehensive  surveillance  procedure  to
monitor  budgetary  policies  in  EMU.  The
aim  is  to  ensure  budgetary  discipline,  thus
helping the ECB to maintain price stability.
Since  a  single  currency  implies  a  greater
role for national fiscal policies in adjusting
to  country-specific  developments,  the  SGP
establishes  the  “medium-term  budgetary
objective of positions close to balance or in
surplus”  which  “will  allow  all  Member
to  deal  with  normal  cyclical
States 

2

0

-2

-4

-6

F iscal d eficits :G eneral governm ent balance

-2.6

-2.2

-1.3

0.2

-0.9

excl. U M TS

-1.3

-4.3

-5.1

199 5

1996

1997

199 8

1999

2000

200 1

S ource: C om m ission, D G

12

fluctuations while keeping the government deficit within the reference value" of 3% of GDP. Under
the SGP, euro-area Member States must update their medium-term fiscal strategy every year through
Stability Programmes4. The Stability Programmes are the main instruments of budgetary surveillance
in EMU and are assessed by the Commission and the Council.

Starting from an unbalanced budgetary situation, the last six years have seen a great deal of progress
towards  achieving  greater  fiscal  discipline.  Actual  budget  balances  in  the  euro  area  improved  up  to
1999,  in  part  due  to  vigorous  consolidation  efforts,  and  many  Member  States  are  now  running  a
surplus. Since then, the favourable performance of some countries was largely due to strong growth,
improvement in underlying fiscal positions being very modest. In 2001 budget deficits have increased
due  to  tax  cuts  that  were  not  fully  offset  by  expenditure  reductions  and  the  operation  of  automatic
stabilisers in the cyclical slowdown.

Since  the  beginning  of  1999,  fiscal  policies  have  been  set  in  the  framework  of  the  SGP.  The  3%
reference  value  has  de  facto  become  a  “hard  ceiling”.  No  Member  State  has  breached  it  Fiscal
adjustment has continued in the majority of countries, albeit at a slowing pace. In 2001, most Member
States had reached budgetary positions fulfilling the “close  to balance  or in  surplus”  requirement  of
the SGP.

Obviously,  the  SGP  played  a  significant  role  in  this  achievement.  Notwithstanding,  these  steps
forward  budget  deficits  are  still  too  large  in  Germany,  France,  Italy  and  Portugal,  impacting  on  the
euro-area-wide aggregates. Further consolidation efforts are necessary to reach positions that are close
to balance in 2004 at the latest. Commitments to this end have been made in the context of the 2001
round of updated stability programmes. As budget deficits in 2001 in Germany and Portugal exceeded
by a wide margin, the targets set in their respective Stability Programmes, approaching the 3% of GDP
reference value, the Commission made a recommendation to the Council to issue an “early warning
under  the  Stability  and  Growth  Pact  regulation.  As  a  result  of  the  discussion  in  Council  on  the
Commission’s draft recommendations for an early warning, Germany and Portugal gave firm political
commitments which responded to the substance of the Commissions concerns.

Overall, a favourable feature of the improvement in fiscal positions is the composition of budgetary
adjustment.  Reducing  the  tax  burden,  where  appropriate  (especially  marginal  tax  rates  on  labour)
eliminating  tax  distortions  and  restraining  current  expenditure  is  the  most  effective  way  to  ensure
durable fiscal adjustment. Recent budgetary developments show that most countries are moving in this
direction. The present adjustment mainly relies on expenditure restraint, while the overall tax burden
has  fallen  as  a  share  of  GDP.  Ongoing  tax  reforms  should  help  to  reduce  the  historically  high  tax
burdens which still prevail in many EU countries. Lowering the tax burden on both capital and labour,
and  especially  low-cost  labour,  should  enhance  physical  and  human  capital  accumulation,  increase
labour-market participation and boost the demand for labour.

Nevertheless, the euro area faces two main challenges in relation to future fiscal policy:

–  Eliminating remaining imbalances and maintaining a neutral fiscal stance: If the euro area
is to enjoy favourable growth and low inflation, it is essential to eliminate the remaining
imbalances  and  maintain  a  neutral  fiscal  stance.  Continued  fiscal  discipline  will  also
facilitate the ECB’s task of achieving price stability. By ensuring that budgetary positions
meet  the  medium-term  objective  set  out  by  the  SGP  of  being  “close  to  balance  or  in
surplus”,  Member  States  will  also  be  able  to  cope  with  normal  cyclical  fluctuations,
to  country-specific  developments,  and  providing  budgetary  room  for
responding 
manoeuvre to make the necessary structural reforms.

4

Non euro area Member States continue to present Convergence Programmes.

13

                                                
–  Preparing  for  population  ageing:  Sustainability  of  public  finances  is  now  part  of
surveillance  in  the  Stability  and  Growth  Pact  framework.  Risks  have  been  identified  in
several Member States. This may require setting more ambitious medium-term budgetary
targets in order to smooth future debt developments.

As  regards  monetary  policy,  the  Treaty  makes  price  stability  the  primary  objective  of  the  ECB.
Monetary policy should also support the economic policies of the euro area, without prejudice to the
goal of price stability. The ECB’s monetary policy strategy consisting of three elements: a quantitative
definition of price stability and "two pillars" used to assess risks to price stability. Price stability was
defined  by  the  ECB  as  a  year-on-year  increase  in  the  HICP  for  the  euro  area  of  below  2%,  to  be
maintained over the medium term. The definition of price stability provides a yardstick against which
the ECB's monetary policy can be assessed for the achievement of its primary objective. Furthermore,
the  ECB  stated that  the  single  monetary  policy  would  adopt  a euro-area-wide  perspective  and  so,  it
would not react to specific regional or national developments. The first pillar of the ECB’s monetary
policy  strategy  attaches  a  prominent  role  for  money,  signalled  by  the  announcement  of  a  reference
value for the expansion  of  broad  money,  M3.  Since  December  1998, the  ECB's  reference  value  has
been set at a growth rate of 4½%. The second pillar consists of an analysis of a wide range of other
economic  indicators such as  cost and  price indices,  the  exchange  rate, real  economy  indicators,  and
financial market indicators, in order to arrive at a broad based assessment of the inflation outlook and
the risks to price stability.

18-Sep-01

5.0

4.5

4.0

3.5

3.0

6-Oct -00

11-M ay-01

31-Aug-01

ECB official interest rates
(standard repo)

In spring 1999, the ECB cut interest rates
against 
the  background  of  declining
inflation  and  uncertain  global  growth
prospects in the aftermath of the financial
crises  in  South-East  Asia,  Russia  and
Brazil.  As  growth  picked  up  later  in  the
year,  and  inflationary  pressures  rising
were  the  ECB  reversed  the  initial  move
by  raising  policy  rates.  During  the  year
2000, the significant increase in oil prices
coupled  with  a  depreciating  euro  shifted
the  balance  of  risks  to  price  stability
upwards.  Meanwhile,  money  growth
remained  above  the  ½%  reference  value
and  credit  to  the  private  sector  continued  to  grow  strongly.  The  ECB  responded  to  increased
inflationary  pressures  by  raising  interest  rates  in  a  number  of  steps.  The  deteriorating  economic
outlook in the world economy, and in particular the US, triggered a series of interest rate cuts in major
economies throughout 2001. The ECB lowered interest rates four times last year, by a cumulative 150
basis points, to a level of 3 ¼%. This was done despite an inflation rate above its upper limit of 2%,
because a good part of the price increases were of a transitory nature, while the weakening economy
was exerting downward pressure on inflation. Prospects that a temporary higher rate of inflation would
not  feed into  inflation expectations,  were
conducive of continued wage restraint.

M onetary growth

9-Apr-99

5-Nov-99

2.0

2.5

Jan-99 M ay-99 Sep-99 Jan-00 M ay-00 Sep-00 Jan-01 M ay-01 Oct-01 Feb-02

9-Nov-01

For most of the time during the first three
years  of  the  single  currency  monetary
growth  was  above  the  ECB’s  reference
value and in the last  quarter of  2001  and
the first quarter of this year outstripped it.
However,  the  recent  strong  monetary
growth was not considered a risk to price
stability  by  the  ECB,  as  it  was  seen  as
mainly  caused  by  portfolio  shifts  into
monetary  assets  in  an  environment  of

8.5

7.5

6.5

5.5

4.5

3.5

M3

reference value

J
a
n
-
9
9

A
p
r
-
9
9

J
u
l
-
9
9

O
c
t
-
9
9

J
a
n
-
0
0

A
p
r
-
0
0

J
u
l
-
0
0

O
c
t
-
0
0

J
a
n
-
0
1

A
p
r
-
0
1

J
u
l
-
0
1

O
c
t
-
0
1

J
a
n
-
0
2

A
p
r
-
0
2

14

increased  uncertainty.  In  this  context,  the  growth  of  M3  above  the  reference  value  did  not  prevent
from reducing further key ECB interest rates following the terrorist attacks in the US in late 2001.

Whilst it is of paramount  importance that  the  ECB  bases its  interest-rate  decisions  on the economic
conditions of the euro area as a whole, differences in inflation rates among the Member States persist.
This,  however,  is  also  the  case,  for  example,  across  single  States  in  the  United  States.  Economic
policies need to be adapted in order to address domestic imbalances in individual euro area countries.

1.4

Coordination of economic policies in EMU

A  sound  economic  policy  architecture  is  enshrined  in  the  Treaty.  It  comprises  a  commitment  to  an
open  market  economy  with  free  competition,  stable  prices  and  sound  public  finances  which  are
conducive to sustainable growth and high employment. It assigns tasks to the various policy-makers
but  leaves  them  independent  (combination  of  the  principles  of  subsidiarity  and  coordination).  The
single monetary policy is entrusted to the independent ECB. Its primary objective is to maintain price
stability. Responsibility for most other economic policies, i.e. national budgetary policy and structural
policies, remains with the Member States.

The  Treaty  provides  for  a  system  of  economic  policies’  coordination,  fostering  positive  spill-over
effects  and  taking  account  of  any  possible  negative  externalities  that  could  occur  when  decision-
making  is  not  coordinated.  The  Broad  Economic  Policy  Guidelines  of  the  Member  States  and  the
Community (BEPGs) are the central element in this system. The annual Employment Guidelines are
the Treaty-based instrument for employment policy coordination. Another important element based on
the Treaty is multilateral surveillance of economic policies.

The BEPGs provide guidance to the relevant policy  makers  with  regard to  both  the  macroeconomic
and  structural  spheres.  And  because  they  are  comprehensive,  these  guidelines  seek  to  ensure
consistency in policy stance, across policy fields and in geographical terms. Multilateral surveillance
has  been  put  into  practice  in  the  form  of  procedures  and  processes  that  aim  to  establish  sound
budgetary  policy  (Stability  and  Growth  Pact)  to  advance  the  process  of  structural  reform  in  labour,
product  and  capital  markets  (the  Luxembourg  and  Cardiff  processes).  In  June  1999,  the  Cologne
European  Council  initiated  the Macroeconomic  Dialogue.  It  brings together  both  policy  makers  and
representatives  of  the  social  partners  for  an  exchange  of  views  on  economic  trends  and  policy
requirements  in  the  EMU  framework.  In  March  2000  the  Lisbon  European  Council  integrated
economic and social reform objectives into a ten-year agenda aimed at becoming the most competitive
and dynamic knowledge-based economy in the  world,  capable  of  sustainable  economic  growth  with
more and better jobs and greater social cohesion.

Both the degree of economic policy coordination and the form it takes vary considerably across policy
areas.  In  any  case,  successful  coordination  rests  on three  elements:  (i)  a  common  assessment  of  the
current economic situation and the outlook; (ii) better understanding of the working of EMU and the
economies of its member states and (iii) the willingness of policy-makers to give and take open and
frank advice, to accept the principle of peer pressure and to adjust policies when necessary.

Assessments of economic policy coordination in EMU, endorsed by the Helsinki and Lisbon European
Councils, have concluded that there is no need for new processes. Moreover, the Barcelona European
Council  stressed  that  the  focus  must  be  on  implementation.  Emphasis  has  been  put  on  learning-by-
doing to make gradual improvements. In the first three years, notable progress has been made in the
following three areas:

The Broad Economic Policy Guidelines

The  BEPGs  continue  to  contribute  to  convergence  in  EMU  and,  in  line  with  the  Lisbon  objectives,
they give priority to improving the EU’s growth potential through economic reform. The BEPGs have
been enhanced in several ways. They have become more operational through the use of more concrete

15

and  specific  recommendations  in  both  the  general  and  country  specific  parts.  Increased  attention  is
also  devoted  to  implementation.  To  this  end  the  Commission  has  introduced  a  comprehensive
implementation  report  that  assesses  the  extent  to  which  Member  States  have  followed  the  policy
recommendations.

The  significance  of  the  BEPGs  has  been  further  enhanced  through  the  greater  involvement  of  the
European Council, as decided in Lisbon. The annual spring meeting of the European Council devoted
to economic and social questions is providing additional political guidance. Moreover, the BEPGs are
now  oriented  towards,  and  draw  on,  work  in  other  relevant  Council  formations  which  assume
responsibility for implementation in their respective areas and contribute to subsequent BEPGs.

The Stability and Growth Pact

The Pact designed to bring about sound budgetary positions in the Member States, a condition for the
smooth functioning of EMU. Implementing the Pact has been helped by the adoption of a new code of
conduct in 2001  governing  the  format  and contents  of  the  Stability  Programmes  submitted  by  euro-
area  Member  States.  The  new  code  makes  it  easier  to  compare  programmes  through  the  use  of
common external assumptions for projections and by having all national programmes submitted within
a  short  period  every  autumn.  In  addition  the  set  of  information  which  has  to  be  provided  has  been
increased to allow better analysis of issues relating to the long-term sustainability of public finances.

The Eurogroup

The  Eurogroup  brings  together  Ministers  from  Member  States  that  have  adopted  the  euro.  The
Commission,  and  where  appropriate  the  ECB,  are  invited  to  participate.  The  group  serves  as  an
informal  forum  for  frank  and  free  discussions  on  EMU-related  issues.  This  informal  forum  has
facilitated  the  establishment  of  common  views  among  Ministers  on  matters  of  mutual  concern.  The
range  of  subjects  covered  has  expanded  from  topics  such  as  cyclical  positions,  budgetary  stances,
exchange rate and capital market developments, to structural issues that have an impact on growth and
public finances. Furthermore, the effectiveness of the Eurogroup has been enhanced by improving its
working procedures and giving it more visibility.

Whilst progress has been made in the first three years of the single currency, there is a need to further
strengthen  policy  coordination.  To  this  end  the  Barcelona  European  Council  endorsed  measures  to
improve  the  common  assessment  of  the  economic  situation.  Work  need  to  be  intensified  on  EMU
statistical requirements. Moreover, in March 2002, the Commission started issuing a regular quarterly
report presenting ongoing analytical work. And with the aim of enhancing the common understanding
of what constitutes good economic policies in EMU, the Commission intends shortly to propose a set
of common standards for conducting economic policies.

16

2.

2.1

MONITORING WAGE DEVELOPMENTS IN EMU

Introduction

The formation of EMU was expected to exert a profound impact on the market players, in particular
affecting  price  setting  and  wage  bargaining  behaviour.  Economic  and  Monetary  Union  has  in
important  ways  changed  the  macro-economic  environment,  which  is  now  characterised  by  a  single,
stability-oriented  monetary  policy  for  the  euro  area,  and  sound  national  fiscal  policies.  The  debate
about  the  likely  impact  of  EMU  on  wage  formation  has  centred  around  three  different,  though
interconnected,  aspects:  (i)  the  necessary  degree  of  nominal  wage  flexibility  to  take  account  of  the
now  more  direct  effects  of  wage  on  price  competitiveness  (ii)  the  direct  impact  on  real  wage
aspirations (the wage-setting curve) and, thus, on equilibrium unemployment; and (iii) the impact on
labour market institutions, in particular wage bargaining mechanisms.

It  has  been  widely  held  that,  in  general,  EMU  should  provide  improved  framework  conditions  for
employment-compatible wage bargaining behaviour as the link between wage and employment trends
becomes more evident and stringent. With the bailout option of nominal exchange rate devaluation no
longer  available,  any  substantial  error  in  wage  setting  would  ultimately  translate  into  a  loss  of
competitiveness, deteriorating labour market conditions and painful adjustment thereafter.

In EMU it is therefore even more important than in the past for wage developments to be in line with
both the macro-economic framework set at the Community level and the individual country-specific
requirements. Thus, wage bargaining behaviour shows that:

(cid:1)  If  overall  nominal  wage  developments  are  not  consistent  with  price  stability,  excessive  nominal
wage increases pose inflationary risks for the euro-zone as a whole with adverse effects on growth
and employment in the entire monetary union.

(cid:1)  Real wage developments that are in line with labour productivity growth  and, take into account,
where necessary, the need to  strengthen the  profitability  of  capacity-enhancing  and  employment-
creating investment avoid deterioration in competitiveness and labour market conditions.

(cid:1)  The  single  currency  increases  transparency  and  facilitates  wage  comparisons  which  may  lead  to
“wage  imitation”.  While  convergence  in  living  standards  is  an  aim  of  the  EU  and  is  likely  to
happen  over  time,  premature  wage  level  catching-up  might  actually  slow  down  or  even  stop  the
process of real convergence.

(cid:1)  Wage agreements that take into account productivity differentials according to qualifications, skills
and geographical areas not only help to avoid job destruction and enhance job creation in general,
but also improve the employment prospects for groups such as the young, low-skilled or long-term
unemployed and  contribute to  the  efficient  reallocation  of  labour  across  occupations,  sectors and
regions.

The  responsibility  for  wage  setting  procedures  and  outcomes  compatible  with  the  achievement  and
maintenance of high employment continues to fall primarily  in  the  domain  of  the  private sector.  As
indicated  above,  inappropriate  wage  developments  -  or,  more  generally  speaking,  inadequate  labour
market structures - in specific countries or regions, particularly when they are big enough to require an

17

offsetting monetary policy response, may have harmful consequences for other members of EMU as
well. Strengthened economic policy coordination could help internalising these effects.

2.2

Aggregate wage developments: some stylised facts

The  last  decade  has  seen  a  remarkable  disinflation  process.  While  the  lacklustre  overall  economic
performance over that period has contributed to a reduction in inflationary pressures, there is evidence
that  the  achieved  high  degree  of  price  stability  has  also  been  the  result  of  the  systemic  changes
associated  with  the  run-up  to  Stage  Three  of  EMU.  With  price  stability  and  a  high  degree  of
sustainable convergence being  key  requirements for  adopting  the  euro,  differences  between  national
inflation rates also narrowed drastically in this process. For the euro area as a whole, nominal wage
growth per employee declined almost in parallel with price stabilisation, with nominal compensation
per worker now set to increase on average by about 3 % annually at the present point in time. At first
glance, therefore, the players in the wage bargaining process appear, in general, to have taken on board
the neet for compatibility with price stability.

6

8

%

10

2000

2001

1999

the 

Nominal wage growth per employee

As  a  by-product  of  nominal
absolute
stabilisation, 
dispersion  of  nominal  wage
growth  across  countries  has
also  diminished  significantly
over the past decade, resulting
in fairly similar nominal wage
developments  in  the  recent
past.  However,  in  2001  the
absolute dispersion of nominal
wage  growth  per  worker
among  the  "big  four"  euro
countries still amounted to 2.7
(ranging
percentage  points 
from 1.6 % in Germany to 4.3
%  in  Spain).  Money  wages
increased somewhat faster in Finland and the Netherlands, reflecting different cyclical positions; the
highest  rates  of  nominal  wage  growth  were  in  Ireland,  Portugal  and  Greece.  As  a  result,  there  still
remains a significant dispersion of rates of growth in money wages in the euro area.5

L NL A

P FIN

D EL

IRL

EA

B

E

F

2

0

4

I

While  convergence to  a  wage  behaviour, that  keeps in  mind  its impact  on  overall  price  inflation,  is
warranted,  cross-country  differences  in  productivity  levels  and  rates  of  growth  actually  limit  the
degree  of  appropriate  wage  synchronisation.  Allowing  wages  to  reflect  country,  regional  or  sectoral
differences  is  a  means  to  allow  real  wage  levels  to  converge  over  time  at  sustained  or  improved
employment levels. Thus, stronger nominal wage increases in some countries enjoying faster growth
of labour productivity need not be a particular cause for concern.

5 When the coefficient of variation in nominal wage growth rates is taken as a yardstick, the relative dispersion
of nominal wage increases appears to have  somewhat increased over time. However, the evidence of  more
closely synchronised nominal wage behaviour is preserved when looking at measures of relative dispersion.

18

                                                
The  stabilisation  in  nominal  unit  labour  cost  developments,  was  accompanied  by  a  decline  in  the
cross-country  dispersion  in  nominal  unit  labour  cost  increases  across  Member  States.  However,  in
2001 some slippage in nominal unit labour cost growth occurred, and there is similarly clear evidence
of overshooting nominal unit labour cost growth in a number of smaller countries.

The slowdown in economic activity in 2001 was accompanied by a pick-up in nominal unit labour cost
growth. For the euro area as a whole, nominal unit labour cost have risen by about 2.5 % last year.
While this is to some extent a reflection of weaker than expected labour productivity growth, several
countries  –  mainly  in  the  euro  area  periphery  –  have  undoubtedly  shown  signs  of  overheating.
Nevertheless, for the area as a whole current expectations are for a deceleration of nominal unit labour
cost growth, currently forecasted to return below 2 % in 2002.

In summary, despite an increase in 2001 nominal unit labour cost inflation in the euro area as a whole
has fallen. Moreover, despite a marked reduction of unemployment over the past few years, up to date
there  have  been  few  signs  of  a significant re-acceleration  of  nominal  unit  labour  cost  growth  in  the
area  as  a  whole.  Admittedly,  several  countries  which  have  experienced  a  few  years  of  sustained
growth  and  where  the  labour  market  has  become  relatively  tight  (Ireland,  the  Netherlands  and
Portugal), appear to be relatively more exposed to eventual wage pressures. Furthermore, the labour
cost  impact  of  the  reduced  working  week  in  France  may  be  felt  more  strongly,  once  compensating
productivity  increases  start  abating.  However,  all  in  all,  the  early  years  of  EMU,  including  several
years of the run-up to monetary union, have seen an impressive amount of nominal wage moderation,
which can hardly be explained without recourse to changes in underlying behavioural relations.6

Corroborating  evidence for  overall  wage  moderation  is  to  be  found  in  the  evolution  of  real  product
wages adjusted for productivity. Obviously, in its simplest form, this boils down to the analysis of real
unit labour cost developments, mirroring changes in the share of labour in total income. Indeed, for the
euro area has a whole, the labour income share remained broadly constant in the first three years of
EMU, after having fallen continuously in the preceding five years.

A  somewhat  closer  look  at  real  unit  labour  cost  developments  over  the  last  three  years  reveals  the
following pattern:

(cid:1)  Real  wage  moderation  has  prevailed  in  almost  all  countries  of  the  euro  area.  Only  in  France,
Luxembourg and Portugal real unit labour cost were higher in 2001 than three years previously.

(cid:1)  In the countries of the former DM-bloc, plus Italy real unit labour cost growth has basically been
flat  over  the  past  three  years;  and  lst  year  Spain  saw  a  pause  in  the  trend  decrease  of  the  wage
share.

(cid:1)  In Ireland and Finland, which had both seen significant declines in real unit labour costs in the pre-
EMU years, the fall in  labour’s share of income came to a halt and the real unit labour cost started
to increase.

6 Put more formally, out-of-sample predictions of wage equations estimated up to the early 1990s generally tend

to over-predict wage developments in subsequent years (OECD 2000).

19

                                                
(cid:1)  Late comer Greece has, over the past three years, registered a pronounced fall in real unit labour

cost, compensating for the real wage push experienced in the pre-EMU years.

110

120

100

to 

1992

2001

has 

recent 

Real unit labour cost index 1995=100

Evidently, 
real  wage
moderation  has  borne  fruit
the
and  contributed 
dynamism  in  job  creation
in 
years.  The
unemployment  rate  of  the
decreased
area 
significantly  from  its  peak
of 11.5 % to below 8.5 %,
yet  wage  developments
remained  subdued.
have 
Thus,  the  NAIRU  of  the
euro  area  might  have
declined  by  about  1  ½
and
percentage 
continues 
to  be  on  a
downward  path,  suggesting  that  about  half  of  the  improvement  in  actual  unemployment  could  be
considered  structural  in  nature.  By  and  large,  other  international  bodies  such  as  the  OECD  and  the
IMF  have  arrived  at  very  similar  conclusions.  Obviously,  we  need  to  understand  the  underlying
mechanisms  behind  the  wage  moderation,  before  we  can  say  whether  or  not  this  process  of  wage
moderation can be sustained.

A P F
N

E F I
R
L

I L N
L

B D E
L

points, 

E
A

90

80

I

2.3

Factors behind the wage moderation observed in recent years

To  better  understand  the  nature  of  the  wage  moderation,  as  reflected  in  the  fall  of  the  NAIRU,
reference should  be  made  to  relatively  widespread  product  and  labour  market  reforms  in  most  euro
area  countries,  spurring  competition  in  goods  and  services  markets  and  cracking  down  on  insider-
outsider divisions in the labour markets during the second half of the 1990s. Employment stimulating
reform efforts7 have addressed, inter alia, tax and benefit systems, for example in the form of cuts in
payroll  taxes  for  targeted  groups  or  in-work  financial  support  for  low-wage  earners,  and  a
modernisation  of  work  organisation,  including  the  facilitation  of  part-time  work  and  more  flexible
work contract arrangements.

Moreover,  the  introduction  of the  single  currency  is  bound  to  increase  the  degree  of  competition  in
product  and  services  markets  by  enhancing  price  transparency  across  EMU  Member  States.8  Thus,
EMU  provides  an  additional  impetus  to    ongoing  efforts  in  the  context  of  the  Single  Market
Programme to improve the functioning of product and service markets. As a result, the potential for
rent sharing behaviour between workers and firms will be strongly reduced.

7 While more active and preventive labour market policies may have helped to the improve the employment

situation, their effect on wage moderation and the NAIRU is ambiguous.

8

Note,  however,  the  more  sceptical  view  of  several  observers  that  integration  may  not  necessarily  imply
intensified competition, because integration also facilitates the strategies of transnational firms potentially
enabling them to establish product market domination across Europe.

20

                                                
Box: Centralisation, coordination and macroeconomic outcomes.

The discussion of how wage bargaining structures affect wage developments has to a large extent been shaped
by the Calmfors and Driffill hypothesis. It predicts an ‘inverted U’ relationship between unemployment and the
degree  of  centralisation  of  wage  bargaining.  Fully  centralised  and  fully  decentralised  bargaining  produce  the
most employment-friendly outcomes, essentially because firm-level bargaining takes the competitiveness of the
firm into account and economy-wide bargaining is concerned with the  macroeconomic employment effects. In
between the two extremes, the externality implications of wage increases on employment are not fully taken into
account, which leads to inferior outcomes. Empirical evidence for the inverted U relationship is, however, weak.
Successful  coordination,  whether  formal  (e.g.  through  wage  norms  agreed  with  government  involvement)  or
informal (e.g. through pattern bargaining) can be understood as a way of overcoming the potential disadvantage
of bargaining at an intermediate level.

While it is difficult to establish precisely the contribution of the various reform efforts, there can be
little doubt that they have had some effect in reducing the NAIRU by helping to keep a lid on wage
demands. However, it must also be acknowledged that the progress on reform has been fairly uneven
across  countries.    All  the  major  economies  of  the  euro  area  still  have  relatively  high  structural
unemployment.

Thus,  it  is  difficult  to  account  for  the  widespread  wage  moderation  without  considering  the  role  of
informal incomes policies in a number of countries9. In the past few years bi- and tripartite agreements
on wage policy have been concluded in Belgium, Denmark, Finland, Germany, Greece, Spain, Ireland,
Italy, the Netherlands and Portugal typically committing the parties involved in collective bargaining
to  some  form  of  wage  moderation  compatible  with  price  stability  and  to  improve  competitiveness.
Governments' involvement in tripartite “social pacts” may take various forms, for example trading tax
cuts  and/or  specific  labour  market  policy  measures  against  wage  restraint,  as  has  recently  been  the
case in Finland and Ireland. Finland has also made an attempt to increase nominal wage flexibility by
the  introduction  of  so-called  "EMU  buffer  funds",10  but  their  impact  will  probably  remain  fairly
limited.

Belgium provides probably the clearest instance of explicitly taking competitiveness into account. In
1996 the government enacted an "employment and competitiveness" law which included a legal wage
norm  for  1997-98,  whereby  pay  increases  were  not  to  exceed  average  increases  in  Belgium's
neighbouring countries, France, Germany and the Netherlands. Indeed, the social partners concluded
new  inter-sectoral  agreements  in  1998  and  2000,  again  incorporating  the  concept  of  a  wage  norm
related  to  wage  trends  in  neighbouring  countries  as  the  key  reference  for  average  Belgian  wage
increases.11

9

10

11

For  a  detailed  discussion  see  for  example  the  European  Industrial  Relations  Observatory  (EIRO),
EIROonline (2000) .
In  periods  of  economic  upturn  social  security  contributions  are  levied  at  a  slightly  higher  rate  than
necessary. During cyclical downturns the accumulated funds can then be used to pay for additional social
security costs.
The most recent framework agreement, concluded in December 2000, caps increases in nominal wages per
employee to a total of 6.4 % for the period 2001-2002.

21

                                                
Box: Social Pacts.

In  the  1980s  and  1990s,  tripartite  social  pacts  (re-)  emerged  in  a  number  of  Member  States;  most  often  this
corporatist approach was chosen against a backdrop of high unemployment and rigid labour market structures.
For  the  government,  tripartite  negotiations  on  structural  reforms  offer  the  advantage  of  indicating  what  is
politically  feasible  at  an  early  stage  and  ultimately  winning  the  social  partners’  active  support  for  the
implementation of an agreement. Furthermore, tripartite negotiations offer the possibility of concluding package
deals  whereby  every  participant  can  claim  at  least  partial  achievement  of  his  goals.  Often,  governments
encourage package deals by offering rewards (e.g. in the form of tax cuts) in the case of success. For the social
partners, tripartite negotiation holds out the possibility of being able to influence policies at an early stage and of
gaining legitimacy.

The run-up to Stage Three of EMU brought additional dimensions into the coordination  process:  on  the  fiscal
side  the  need  to  fulfil  the  Maastricht  criteria  and  the  disinflation  process  on  the  monetary  side;  the  latter  also
strengthened the focus on wage developments. However, the pressure that had favoured social pacts in the first
place  might  have  eased  with  the  launch  of  the  single  currency  and  the  favourable  growth  conditions  in
1999/2000.

Coordinated wage bargaining at the national level has helped to sustain wage moderation. However,
such arrangements face a fundamental problem of time consistency, making it difficult to lock in the
bargain. In particular, with free capital mobility the effectiveness of mechanisms to bind employers to
policies of high investment is fairly limited. In turn, this reduces the incentives for labour to exercise
wage  restraint  in  anticipation  of  future  investment.  Governments  may  hence  find  it  increasingly
difficult to design supportive policies deemed acceptable by the main actors in wage bargaining.

At the same time, with inflation in the euro area converging at fairly low levels, the role of generalised
wage restraint has become less important, while the importance of greater nominal wage flexibility for
the smooth functioning of EMU has increased. Experience suggests that co-ordinated wage bargaining
at  the  national  level  tends  to  produce  results  orientated  towards  certain  general  economy-wide
indicators, instead of regional, company and skill specific needs. Provided that it allows for flexible
adjustment at lower bargaining levels, co-ordinated bargaining itself may deliver fairly differentiated
outcomes.  In  recent  years  there  has  been  a  move  in  several  countries  towards  "centralised
decentralisation" in wage bargaining, for example in the form of ”opening clauses”, which allow for
some degree of firm-level differentiation. However, centralised bargaining was sometimes unable  to
quickly  correct  wage  developments  out  of  line  with  productivity.  In  such  cases,  the  ensuing  loss  of
competitiveness  may  build  up  over  quite  some  time,  before  the  inevitable,  and  painful  adjustment
kicks in.

With  labour  market  policies  geared  towards  mobilising  the  labour  force  potential,  by  means  of
comprehensive structural reforms aimed at increasing participation rates, overall wage pressures may
indeed  remain  subdued.  Accompanying  structural  reform  also  facilitates  the  transition  towards  a
higher degree of in-built wage differentiation.

So far progress has been made in reforming labour market institutions in the euro area, and there can
be little doubt that in general wage bargaining institutions and wage setting practices have responded,
quite  favourably  to  the  new  economic  environment,  both  in the run-up  to  Stage  Three  of  EMU  and
during its first three years. Over the medium term, the driving forces of price transparency, increasing
capital  mobility,  trade  integration  and  competition  are  likely  to  increase  the  real  wage  elasticity  of

22

demand for labour. This should foster employment-compatible wage bargaining behaviour as the link
between wage and employment trends ultimately become much more evident and stringent.

3.

INVESTMENT AND THE EURO AREA GROWTH POTENTIAL

3.1.

Investment trends in the euro area in the 1990s

Public and private investments are crucial to the development of the euro area’s growth potential over
the medium and longer term since it determines the structure and size of the capital stock and acts as a
conduit for the penetration of new technologies While the empirical evidence is still inconclusive12, it
is nevertheless clear that EMU offers significant upside potential for investment in the euro area for
three reasons:

–  By acting as a complement to the single market programme, the euro fosters competition

and reduces exchange rate risks.

–  As the drive towards greater financial market integration deepens, financing conditions for
firms are expected to improve in general and cross border investments will become easier.

–  At  the  level  of  economic  policies,  it  is  expected  that  EMU  will  act  as  a  catalyst  for
structural  reforms,  in  particular  in  labour  markets.  On  the  fiscal  side,  lower  deficits  and
falling debt ratios will have an impact on interest rates, and create room for private sector
activity.

While  the  upside  investment  potential  provided  by  the  EMU  framework  is  clear,  it  should  be
underlined  that  realising  that  potential  will  require  significant  policy  efforts  in  both  the  macro  and
microeconomic arenas over the coming years. The extent of the challenge is revealed by an analysis of
historical  trends.  The  euro  area’s  lacklustre  investment  performance  during  the  1990s  is  widely
considered  to  be  a  major  factor  behind  the  area’s  relatively  poor  actual  and  potential  growth
performance. This chapter tries to isolate factors, which are crucial in determining investment trends,
with particular emphasis on those on which EMU is likely to impact directly or indirectly.

the 

During  most  of  the  1990s,  the  euro  area’s
investment  performance  was  poor.  The
investment  recovery  of 
late  1990s
appears  slow  compared  with  the  previous
investment  cycle,  which  began  in  1986,
lasted 5 years and reached peak growth rates
for  total  investment  of  7  %.  In  contrast,  the
recovery  of  the  late  1990s  was  both  shorter
and  less  pronounced,  with  annual  growth
rates  not  exceeding  5  %.  Investment  shares
show  a  similar  picture  of  a  more  muted

15%

14%

13%

12%

11%

10%

9%

8%

7%

6%

Investment in equipment and structures

(Share of GDP in %)

1
9
8
0

1
9
8
2

1
9
8
4

1
9
8
6

1
9
8
8

1
9
9
0

1
9
9
2

1
9
9
4

1
9
9
6

1
9
9
8

2
0
0
0

2
0
0
2

Construction investment

Equipment investment

12 Given the short time that has elapsed since the start of the EMU process, it is clearly too early to attempt an

empirically comprehensive assessment of its impact on investment in the euro area.

23

                                                
recovery in the 1990s, progressing steadily between 1997 and 2000 but still remaining below its peak
of the late 1980s. Investment growth was unusually buoyant in the second half of the 1980s13.

The  overall  investment  trend  can  be  disaggregated  into  construction  and  equipment  investment  or,
alternatively,  into  public  and  private  investment.  The  construction  sector,  accounting  for  more  than
half of total investment, played an important role in the subdued investment performance of the euro
area after the 1992-93 recession In contrast, the expansion phases of the equipment investment cycles
in the 1980s and 1990s seem rather similar both in terms of duration and growth rates. Average growth
rates were slightly slower during the expansion of the 1990s but, in 2000, real equipment investment
was  significantly  higher  as  a  share  of  GDP  than  at  the  peak  of  the  previous  investment  cycle.
Approximately three quarters of total corporate investment spending is on equipment, as witnessed by
a  sustained  growth  pattern  during  most  of  the  second  half  of  the  1990s.  Also,  the  share  of  ICT
expenditure in total GDP has increased in recent years.14 Contrary to business investment, government
investment  (partly  as  a  result  of  privatisation)  saw  its  share  in  GDP  decline  continuously  between
1991 and 1998, after which it remained broadly stable. Consequently if we exclude construction and
public investment the picture from the 1990’s in terms of equipment investment is encouraging with
business investment in this area having accelerated since the mid 1990s, especially in real terms, and
prices in the ICT sector declining sharply. Business investment (as a share of GDP) has reached levels
similar to the peak in the late 1980s.

3.0%

4.0%

- share o f GDP  -

country 

reduction 

Dispersion of real business investment

in 
variation 
rates,  while 

Over  the  1990s  there  was  a
the
considerable 
of
cross 
investment 
the
dispersion  of  investment  rates
over  the  rest  of  the  OECD15
countries,  remained  fairly  stable.
foreshadowed 
This 
the
in 
convergence 
economic
stricter
and 
conditions 
synchronisation of policies in the
run-up  to  Stage  Three  of  EMU.
Surprisingly,  the  trend  of.  real
convergence  was  even  more
marked 
advanced
for  more 
economies  than  for  the  cohesion  countries.  Since  1999,  however,  dispersion  in  rates  of  business
investment has not declined any further, and in more recent years there has even been  a slight increase
caused to some extent by more buoyant investment in the countries catching up.

Wit hin Euro area
Cont rol group, non euro area OECD

within euro area (cohesion count ries excluded)

2.0%

1.0%

2000

1995

1990

1980

1985

13 This buoyancy reflected, at least partly, anticipation  of completion of the Single Market.
14

In  a  recent  study  the  ECB  (ECB  WP  122,  New  Technologies  and  Productivity  Growth  in  the  euro  area,
Vijselaar and Albers) estimates that the contribution of ICT investment to output growth in the Euro Area has
increased from 0.37 percentage points over the period 1991-95 to 0.74 percentage points in 1996-99.
Including Denmark, Sweden and the UK.

15

24

                                                
Box:

Foreign direct investment

Throughout the 1990’s European integration gradually removed barriers to foreign direct investment (FDI) and
to direct ownership by foreign companies. The introduction of the euro has further reduced barriers to intra-euro
area investment flows arising from the potential variability of exchange rates, and from likely reductionsin the
home-country  bias  in  private  sector  portfolios.  At  the  same  time  trade  barriers  have  been  lowered  and
consequently to the extent that FDI is a substitute for trade flows the overall impact of integration is ambiguous.

Both outflows of FDI from the euro area and inflows into the region increased significantly during the second
half of the 1990s. Some comment seems necessary regarding the high level of net FDI outflows in recent years
appear necessary. Net FDI outflows  from the euro area surged during the second half  of  the  1990s,  averaging
more than 1 % of GDP between 1996 and 1999. FDI data indicate that investment by companies based in the
Euro Area actually recovered much more strongly during the second half of the 1990s, than shown by national
accounts data on business investment. Analysis of geographical and sectoral data confirms that the surge in net
FDI flows in recent years was largely driven by the strategic decisions of multinational corporations in a limited
number  of  sectors  and  geographical  areas,  probably  more  linked  to  global  expansion  than  motivated  by
differences in expected profitability. Data for 2000 reflect large inflows to Germany and large outflows from the
UK, to M&A activities in the telecom sector. There is no convincing empirical evidence so far that FDI flows
have responded strongly to differences in competitiveness within the euro area.

3.2

Determinants of investment in the euro area

Economic  theory  points  to  three  main  macroeconomic  factors  in  determining  investment:  aggregate
demand,  the  cost  of  capital  and  profitability.  Given  the  particular  significance  of  productivity  and
potential  growth,  a  simple  and  direct  test  of  the  relative  importance  of  the  key  macroeconomic
variables  was  carried  out  using  profitability,  relative  investment  prices  and  real  interest  rates  as
variables to explain investment in equipment. As anticipated research results show the positive impact
of  higher  profits,  relative  investment  prices,  lower  real  interest  rates  and  lower  taxes.  A  sustained
increase in profitability of 1 percentage
point 
in
the 
equipment  share  in  GDP  by  0.10  to
0.15  of  a  percentage  point.  A  similar
fall in relative investment prices or real
interest 
the
equipment  share  by  about  0.05  of  a
percentage point.

After tax profitability in the euro area

rates  would 

investment 

increases 

raise 

13%

14%

12%

11%

P
D
G
o
t

Since the early 1990s, there has been a
noticeable,  continuing  upward  shift  in
after-tax profitability16 in the euro area.
At  the  same  time,  growth  has  become
more 
implying  a
significant decline in capital for labour

labour-intensive, 

o
i
t

a
r

10%

9%

8%

0
8
9
1

2
8
9
1

4
8
9
1

6
8
9
1

8
8
9
1

0
9
9
1

2
9
9
1

4
9
9
1

6
9
9
1

8
9
9
1

0
0
0
2

16    Measured  as  GDP  at  market  prices  minus  labour  income  (excl.  self  employed),  times  one  minus  effective

corporate tax rate, all in percent of capital.

25

                                                
 
 
substitution. This trend reflects both the secular movement towards a more service sector dominated
economy and the long period of sustained wage moderation. Unfortunately, so far the relatively large
increase  in  profitability  does  not  appear  to  be  translating  into  an  equally  strong  overall  investment
performance.  More  encouragingly,  EMU  has  had  positive  effects  on  investment  by  reducing
uncertainty, as volatile exchange rates between euro area member states are a thing of the past, as are
lower short and long-term interest rates as a result of EMU’s sound fiscal policy framework.

also 

shown 

expected, 

determinants 

As 
fundamental
macroeconomic 
of
a
investment  have 
considerable  degree  of  convergence  in
recent  years.  The  dispersion  of  after-
tax  profitability,  measured  by 
its
standard  deviation,  has  nearly  halved
since 
the  end  of  the  1980s  with
especially  marked  decline  in  the  early
90s.  Similarly,  real  interest  rates  have
shown  signs  of  convergence  as  well.
Convergence  of  profitability  reflects
increased  product  market,  and  labour
market  competition,  but  also  higher
financial
capital  mobility  due 

to 

liberalisation.  This, 
together  with
increased synchronisation  of fiscal  and
monetary  conditions  within  the  euro
area  explains  the  convergence  of  real
interest  rates.  Nevertheless,  country
specific factors continue to play a role.
Irish
The  exceptional 
investment has been accompanied by a
after-tax
substantial 
increase 
profitability.  Portugal 
the  only
country  where  profitability  has  been
declining  over  the  last  three  years,  but
as real interest rates have fallen too, the
investment rate has changed very little.

increase 

in 
is 

in 

Real interest rate (percent)

7

6

5

4

3

2

1

0

1980

1985

1990

1995

2000

Short-term interest rate

Long-term interest rate

Dispersion of real interest rates across the euro area

5

4

3

2

1

0
1980

1985

1990

1995

2000

within EURO area

within EURO area, excluding GR,ES,IR,PO

While  the  traditional  macroeconomic  variables  appear  to  explain  investment  behaviour  in  the  euro
area to some extent, macro-economic factors are also important . It is clear that structural rigidities in
the financial, labour and product markets need to be addressed if EMU is to achieve its full potential in
terms of enhancing the economic  environment for investment.  Stock  market  variables  are  positively
correlated with investment growth in cross-country comparisons. Similar linkages exist for indicators
of stock market size, liquidity and prices. This is not surprising as firms invest to increase profits and
shareholders assess the value of firms according to expected future profits. The evidence available so
far suggests that stock markets as a source of financing are particularly important for enterprises in the
ICT sector, which have been a main driver of investment growth in the US. Product market regulation
seems  to  be  another  structural  determinant  that  has  a  significant  effect  on  investment  behaviour.
Indicators  constructed  by  the  OECD  to  gauge  differences  in  regulatory  patterns  across  countries,

26

consistently  show  that  more  restrictive  regulation  goes  hand  in  hand  with  lower  rates  of  investment
growth.  In  particular,  indicators  linked  to  the  extent  of  public  ownership  (size,  scope  of  public
enterprises and their corporate control), the state’s involvement in business operations (price controls,
use  of  command  and  control  regulations)  and  barriers  to  entrepreneurship  (regulatory  opacity,  large
administrative burdens on start-ups and barriers to competition) are negatively linked with investment
activity. Finally, labour market rigidities may have held back investment in the euro area. Indeed, the
OECD Employment Protection Legislation Indicator is negatively related to real investment growth.
Other quantitative structural labour market variables point in the same direction, e.g. the “tax rate on
low wage earners” and the “duration of unemployment benefits”.

From the evidence presented, there seems to be both a need and scope for improving the investment
environment  in  the  euro  area,  with  EMU  providing  the  potential  for  that  to  happen.  A  sustained
increase in the rate of fixed capital formation would move the euro area onto a path of permanently
higher living standards. An increase in the share of investment in GDP would raise the area’s growth
potential in the very short term – and in the longer term too if  technological progress is incorporated
into  a  more  modern  capital  stock.  Evidence  on  the  determinants  of  investment  point  to  the  need  to
address a series of structural rigidities in the euro area with the objective of improving the investment
climate.  In  this  regard  a  wide  range  of  possible  structural  reform  measures  are  under  consideration,
covering  labour  market  reforms,  reductions  in  corporate  taxes,  and  product  and  financial  market
reforms that increase competition and reduce monopoly rents.

To conclude, EMU has the potential to significantly improve the investment environment in the euro
area  and  to  act  as  a  powerful  counterweight  to  the  negative  impact  on  growth  of  factors  such  as
declining  populations.  EMU  is  expected  to  play  this  positive  role  (a)  by  fostering  competition  and
reducing exchange rate risks, thus impacting on a range of investment determinants; (b)  by acting as a
catalyst  for  financial  market  development;  and  (c)  by  encouraging  a  range  of  macro-  and  micro-
economic reforms which will promote investment.

27

4

4.1

THE EURO AREA FINANCIAL SYSTEM

Overall developments in the EU financial system

In recent years, there has been a visible acceleration in the process of development and integration of
EU  financial  markets.  There  are  three  main,  interrelated  factors  behind  this  acceleration:  (i)
globalisation, fostered by the liberalisation of international capital movements, financial deregulation
and advances in technology; (ii) progress in creating a common regulatory framework across the EU
(as part of the effort to complete the Internal Market in financial services), accompanied by financial
reforms in the Member States; and (iii) the changeover to the euro.

Before January 1999, the need to operate in many national currencies was a major obstacle to financial
integration  in  the  Union.  The  presence  of  an  exchange  rate  risk  limited  the  attractiveness  of  cross-
border  investment,  reduced  the  incentive  to  proceed  with  regulatory  harmonisation  at  the  EU  level,
and  dampened  competitive  pressures  on  the  Member  States'  home  markets.  The  changeover  to  the
euro as the single currency of twelve Member States has altered this situation. The euro has eliminated
exchange risk as a source of fragmentation in the euro area financial system and at the same time it has
highlighted  the  opportunity  costs  of  the  remaining  sources  of  fragmentation  in  the  system.  Deeper
integration due to the euro is reflected in more homogeneous markets, a wave of consolidation among
intermediaries  and  exchanges  and  the  emergence  of  new  and  innovative  products  and  techniques.
Market operators have adopted more pan-European strategies, and policy-makers have responded by
assigning  a  high  political  priority  to  the  completion  of  the  internal  market  for  financial  services.  In
addition, there is now a greater incentive to intensify domestic reforms as a means of preserving the
competitiveness of  previously protected national financial systems.

Financial structures in the euro area and the US (end-2001, in % of GDP)

Bank deposits

Bank loans
– 
– 
–  general government

to corporation
to households

Outstanding debt securities
   Issued by
–  corporations
–  financial Institutions
–  public sector

Stock market capitalisation

euro area

US

64.3

108.2
42.7
45.7
12.4

90.6

5.8
28.7
52.7

73.3

60.6

50.7
16.1
34.6
0.0

148.6

24.2
43.1
84.4

138.7

Sources: ECB (euro area bank deposits and loans), Federal Reserve (US bank deposits and loans), Eurostat (euro area and US
GDP, stock market capitalisation), BIS (debt securities). For the US, bank deposits and loans are aggregates for commercial
banks,  credit  unions  and  saving  institutions  (data  from  Fed,  Flow  of  Funds).  For  the  US,  public  sector  outstanding  debt
securities include those issued by Government-Sponsored Enterprises or Federally Related Mortgage Pools

28

US  financial  systems  are  seen  as  predominantly  market-based  and  the  euro  area  system  as
predominantly bank-based.17 This is still valid. In particular, bank financing plays a much bigger role
in  business financing  in  the  euro  area  than  in  the  US.  In  the  US,  direct  issuance of  securities  is  the
dominant means of business financing, as reflected in the large outstanding amounts of debt securities
and  stock  market  capitalisation.  In  spite  of  these  differences,  it  is  noticeable  that  in  both  economic
areas the whole range of instruments and intermediaries play an important role.

In the euro area, advances in information processing, liberalisation and market integration (including
through  the  removal  of  twelve  different  currencies),  are  to  favouring  the  development  of  capital
markets relative to bank finance. However, there is no theoretical or empirical evidence to suggest that
a  more  securitised  financial  system  would  be  superior  to  the  current  bank-oriented  system.  Other
characteristics  have  come  to  be  regarded  as  more  relevant  for  the  overall  efficiency  of  a  financial
system - for instance, its completeness and adaptability18.

The  euro  area  financial  sector  is  experiencing  a  phase  of  rapid  structural  change,  in  which  deeper
integration  of  national  markets  is  accompanied  by  a  general  expansion  of  the  financial  sector  and
heightened  competition  between  the  available  instruments  and  intermediaries.  Due  to  the  specific
characteristics  of  the  various  components  of  the  financial  industry,  developments,  in  particular  in
respect to integration, have been rather uneven across markets.

4.2

Money and derivatives markets

From  1  January  1999,  the  ECB  monetary  policy  operations  have  been  implemented  in  euro  on  the
basis  of  the  area-wide  demand  for  liquidity,  without  discrimination  between  the  individual  liquidity
needs of national banking systems. Some problems with the ECB’s liquidity allotment procedures in
the initial period were effectively addressed by the move to floating rate tenders in June 2000. While,
from  then  onwards,  the  euro-denominated  money  market  has  functioned  smoothly,  the  degree  of
integration varies across its different segments..

In  the  market  for  unsecured  inter-bank  deposits,  integration  is  virtually  complete  and  there  is
practically full convergence in very short-term interest rates across the euro area. Such convergence in
interest rates is also reflected in the full acceptance by market operators of EONIA (Euro Overnight
Index Average) and EURIBOR (Euro-Inter-Bank Offered Rate) as uniform price references. Interest
rate convergence has also been helped by the efficient distribution of liquidity area-wide: cross-border
transactions  account  for  a  large  part  (about  60  %)  of  total  inter-bank  activity  of  the  largest  market
participants.  There  are  indications  that  the  inter-bank  market  has  developed  a  two-tier  structure  in
distributing  liquidity,  with  relatively  large  banks  dominating  cross-border  transactions  and  smaller
banks relying on domestic transactions with larger banks for their funding. Interest-rate convergence is
also evident at somewhat longer maturities in the money market.  Analysis by the BIS 19 has pointed to

17

In comparing the euro area financial market to the US, it should be stressed that the euro area is fundamentally different
from the US because it is a union of countries and not one single country. Despite much progress in financial integration,
the  euro  area  financial  sector  is  still  characterised  by  different  national  legal  and  regulatory  systems,  markets
conventions, etc..

18 A  complete  financial  structure  offers  a  company  the  financing  through  markets  and  intermediaries  which  best
corresponds to its needs at the different stages of its life. An adaptive structure provides leeway for the evolution of new
forms of financial intermediaries or contract forms, if the business environment changes.

19 Bank for International Settlements (2000), 70th Annual Report.

29

                                                
the decline of 40 % in bid-ask spreads on 3-month euro-currency deposit rates in 2000 relative to 1996
as further evidence of integration in the euro unsecured money market.

In parallel with developments on the unsecured money market, the euro-area derivatives market is also
highly integrated. The cross-border market for euro interest rate swaps has expanded sharply since the
introduction of the euro, and the high degree of market integration is reflected in very narrow bid-ask
spreads  and  relatively  large  outstanding  amounts.  Activity  in  other  derivatives  markets  has  also
increased, with EURIBOR-based futures contracts displacing all futures contracts in legacy currencies
that existed before EMU.

The secured money market segments (e.g. private repurchase agreements, Treasury bills, commercial
paper  and  certificates  of  deposit,  which  involve  the  exchange  of  liquidity  for  collateral)  remain
considerably  less  integrated.  This  state  of  affairs  reflects  difficulties  in  the  cross-border  use  of
collateral,  mainly  due  to  national  differences  in  market  practices,  regulations  and  the  tax/legal
treatments  that  apply  to  the  securities  used  as  collateral.  These  national  differences  are  reflected  in
segmented  national-based  market  infrastructures  and  can  create  important  practical  difficulties  in
cross-border  clearing  and  settlement,  as  stressed  in  a  recent  report  by  the  Giovannini  Group20.  The
collateral directive, which is to be fully implemented by 2003, will address present difficulties in the
cross-border use of collateral and help to integrate EU financial markets further, e.g. by determining
which law governs cross-border collateral arrangements.

4.3

Bond markets

The  introduction  of  the  euro  has  integrated  the  national  bond  markets  of  the  participating  Member
States,  resulting  in  a  substantially
euro-
homogenous 
more 
denominated  bond  market.  The
effects of integration are evident in
many aspects of market activity.

Total issuance of long-term debt securities (EUR bn)

1,600

1,800

1,400

the  greater 

liquidity  and
First, 
depth  of 
the  euro-denominated
market has been reflected in higher
issuance  volumes.  Total  domestic
issuance  in  euro  since  January
1999  has  exceeded  the  combined
issuance 
currencies
immediately
during 
preceding EMU. Euro issuance was
particularly  strong  in  1999,  rising
by  20  %  relative  to  1998.  This
in  issuance  reflected  the
surge 

the  years 

legacy 

in 

1,200

1,000

800

600

400

200

0

0
9
9
1

1
3
9
9
9
9
1
1
by euro area residents

2
9
9
1

Source: ECB 

5
9
9
1

4
9
9
1
by non-euro area residents (from 1999)

6
9
9
1

7
9
9
1

8
9
9
1

9
9
9
1

0
0
0
2

1
0
0
2

20 The Giovannini Group is a group of market participants, under the chairmanship of Alberto Giovannini, established to
advise the Commission on the financial market. In November 2001, the Group issued a Report on “Cross Border Clearing
and Settlement Arrangements in the European Union”. The Report, published as European Commission Economic Paper
No.163, is available at
http://europa.eu.int/comm/economy_finance/giovannini/clearing_settlement_en.htm .

30

                                                
 
release of pent-up demand on the part of both issuers and investors, who had delayed their entry into
the market because of turbulence in the international financial system and uncertainty surrounding the
changeover  to  the  euro.  Corporate  issuers  were  particularly  active  in  the  early  months  of  1999,  as
many  endeavoured  to  establish  a  position  in  the  new  and  potentially  more  liquid  market.  In  2000,
however, euro issuance declined by 6 % (including issuance by non euro area residents for which data
are available only since 1999), with the return to a more normal rhythm of issuing activity, reduced
government borrowing needs and a progressive deterioration in market sentiment as interest rates and
oil  prices  moved  steadily  higher.
The trend in euro issuance showed
a  sharp  upturn  at  the  beginning  of
2001. Despite a deceleration in the
later part of the year, total issuance
in  2001  was  16  %  up  from  the
previous year. The strength of euro
issuance  in  2001  can  be  traced  to
the corporate and  financial  issuers,
who  responded  to  the  improved
and
bond  market 
weakness in global equity markets.

Gross issuance of euro-denominated long-term debt 
securities by type of issuer

Asset-Backed
Securities

conditions 

Pfandbriefe

Corporates

0.70
0.60

0.90
0.80

0.40
0.30

0.20
0.10

Financials

1.00

0.50

0.00

2000

1999

2001

Source: Commission Services 

Second,  relative  to  the  pre-EMU
situation,  there  has  been  a  sharp
rise  in  the  share  of  private  sector
relative  to  sovereign  issuance.  This  shift  in  the  composition  of  bond  issuance  is  the  result  of  both
reduced financing needs of the euro area governments following the 1990s fiscal retrenchment, and a
surge  in  issuance  by  financial  and  non-financial  corporations.  In  particular,  the  relatively
underdeveloped  market  in  non-financial  corporate  bonds  has  recorded  exceptionally  rapid  growth
rates, with total issuance rising from €27 billion in 1998 to €97 billion in 2001. Further evidence of
increased  liquidity  in  the  corporate  and  financial  segments  of  the  market  is  to  be  found  in  the
progressively larger size of individual issues, with tranches above €1 billion now commonplace. 21 In
the non–financial corporate market segment, the rise of issues by lower-rated corporations is also an
indication of a relatively liquid market, although the share of high-yielding issues remains relatively
small. The trend toward greater securitisation undoubtedly reflects higher investor demand in the more
liquid  euro-denominated  bond  market,  as  well  other  factors  not  directly  related  to  euro,  such  as  the
need  to  finance  increased  M&A  activity  and  UMTS  auctions  that  have  stimulated  the  supply  of
corporate and financial bonds.

Gen. government
and
supranationals
Agencies

Despite its lower share in total issuance, sovereign issuance remains a dominant source of supply to
the  euro-denominated  bond  market.  In  2001,  it  still  represented  more  than  40%  of  total  issuance  in
euro.  The  homogeneity  of  the  euro-area  government  bond  market  is  evident  in  highly  convergent
yields across the Member States, which is in marked contrast to the situation that existed as recently as
the mid-1990s. The convergence in yields can be attributed to the elimination of exchange risk and to
the relative improvement in budgetary conditions in several of the Member States. However, there is
still evidence of fragmentation of liquidity in this market segment, as government bonds are issued by

21 Freddie Mac, the US quasi-governmental mortgage agency, began a significant euro issuance programme in

September 2000, planning to issue of EUR 5 billion per quarter in varying maturities.

31

                                                
60

80

70

90

100

government 

instruments. 

(GR: 391bps in 1998, 181 
bps in 1999)

10-year yield spreads versus Germany (basis points)

twelve  separate  agencies  with
different borrowing requirements,
issuance,  strategies,  procedures
and 
Liquidity
premiums  seem  to  have  emerged
as  an  important  determinant  of
euro-area 
yield
spreads  -  especially  for  smaller-
issuing Member States, several of
to
which  would  be  expected 
enjoy  relatively  low  credit  risk
due to their favourable budgetary
positions.  It  shows  that  for  most
countries  ten-year  spreads  versus
Germany  were  somewhat  wider
in  2001 
in  1998.  The
preference enjoyed by the German ten-year Bund also reflects the fact that the Bund is deliverable into
the  future  contract  in  Eurex,  which  has  become  predominant  in  the  euro  area.  An  active  derivative
market ultimately promotes better liquidity of the underlying security.

than 

2000

1998

2001

1999

NL 

FIN

IRL

GR

10

20

40

30

50

B

A

P

E

L

F

0

I

Third,  as  issuance  volumes  have
risen, the euro has emerged as the
second  most  important  currency
for  international  bond  issuance.
The  US  dollar  and  euro  now
dominate  international  issuance,
representing  more  than  90  %
total22.  The  euro’s  share  of
international 
almost
matched  that  of  the  US  dollar  in
1999,  but  fell  back  sharply  in
2000.  In  2001,  the  euro’s  share
was 44 %, compared to 48 % for
the US dollar.

issuance 

4.4

Equity markets

Net issues of international bond and notes (USD bn)

1,200

1,000

800

600

400

200

0

1994

1995

1996

1997

1998

1999

2000

2001

EUR 

USD

other currencies

Source: BIS, Quarterly Review: International Banking and Financial Market Developments 

The  euro,  by  eliminating  exchange  risk,  has  stimulated  demand  for  cross-border  equity  investment.
Other  forces  have  contributed  to  the  trend  toward  cross-border  trade,  such  as  the  growing

22 The  BIS  international  debt  securities  database  covers  three  types  of  instruments:  securities  denominated  in  a  currency
other than that of the market in which they are issued (“eurobonds”); securities denominated in the currency of the market
in which  they  are  issued,  but  issued  by  non-residents  (foreign  bonds,  such  as  “Yankee”  bonds  in  the  US  market);  and
securities denominated in the currency of the market in which they are issued, issued by residents, but targeted at non-
residents (BIS Quarterly Review, March 2002).

32

                                                
internationalisation  of  equity  issuance,  more  mergers  and  acquisitions  across  borders  and  the
consolidation of formal stock exchanges.

230

Selected  euro area and US stock market indices. Jan. 1998=100

Apart  from  these  structural  developments,  the  integration  in  EU  equity  markets  has  been  evident
mainly  in  a  more  sectorally  correlated  movement  in  equity  prices  across  the  various  Member  State
markets. This indicates a change in
from
investor  behaviour  away 
country-based 
and
investments 
toward  sector-based  investments,
with divergence in the evolution of
indices 
by
differences in composition. The use
of  equity  related  derivatives  has
in
also 
recent  years,  enhancing  primary
equity market liquidity.

explained  mainly 

significantly 

increased 

200

140

170

110

80

50

the 

euro 

effect  of 

in
The 
encouraging  cross-border  equity
investment  has  been  a  factor  in
stimulating  activity  in  the  new-
economy  stock  markets  of  the  EU  which  –  in  line  with  US  developments  –  have  exhibited  rather
extreme  behaviour  in  recent  years,  reflecting  the  ups  and  downs  of  demand  for  TMT  (technology,
media and telecommunications) securities.

Spain 
DJ Euro Stoxx 50

Germany
Italy 

France
US

The response of formal stock exchanges to increased competition, including from the many electronic
trading networks established in recent years, has been to consolidate. While consolidation has been a
global  rather  than  Europe-specific  phenomenon,  there  have  been  several  high-profile  consolidation
efforts  in  Europe.  The  most  notable  of  these  has  been  the  creation  of  Euronext,  which  merged  the
Amsterdam,  Brussels  and  Paris  exchanges  in  mid-2000  and  subsequently  expanded  to  include  the
Lisbon exchange in 2002. Not all consolidation efforts have been successful, however, with the failed
merger of Deutsche Börse and the London stock exchange a prominent example.

As  trading  exchanges  consolidate,  EU  post-trading  infrastructure  is  also  slowly  being  transformed.
Historically,  the  pattern  of  European  securities  trading  has  followed  national  lines,  resulting  in
efficient structures for securities transactions at the national level, usually with  the vertical integration
of  the  trading,  clearing,  settlement  and  depository  functions.23  These  nationally  based  structures  –
offering only very limited scope for cross-border trading - have by and large survived until today. The
various national systems use specific market practices and are subject to different frameworks for the
regulatory,  legal  and  fiscal  treatment  of  securities.  This  state  of  affairs  causes  additional  costs  for
cross-border securities trading in the European Union, both direct costs in the form of higher prices for
the services provided and indirect costs relating to of inefficiencies in the functioning of the financial
system, e.g. additional costs for back-office to reach several markets. The limited consolidation which

23 See Giovannini Group Report on “Cross Border Clearing and Settlement Arrangements in the European Union”, op. cit..

33

                                                
has  taken  place  so  far  has  mainly  concerned  clearing  houses,  whereas  the  configuration  of  security
settlement systems has not changed much compared to the pre-euro situation.24

4.5

Venture capital

Venture capital is typically a small share of overall business financing.  Nevertheless,  its importance
goes far beyond its share because venture capital occupies a key place in the initial stages of the life-
cycle of a firm.

In the euro area, partly due to initiatives at EU level such as the Risk Capital Action Plan (RCAP) of
April 1998, the venture capital industry grew rapidly in the 1990s. In more recent years, the industry
has suffered a set-back linked to the economic slowdown and the large price fall correction in stock
markets  for  high-growth  companies  in  the  course  of  2000.  However,  the  correction  in  the  venture
capital market can be seen as a necessary consolidation and the industry remains structurally sound. A
notable development has been the growing involvement of institutional investors, in particular pension
funds, in this market.

Despite this growth, the Commission in its October 2001 mid-term review of the RCAP observed that
European risk capital markets remain fragmented – with the largest part of private equity investment
undertaken domestically - and that the gap with the US had widened between 1998 and 2000. In 2001,
venture capital investment in the euro area totalled € 8.8 billion (0.13% of GDP), down from € 12.5
billion in 2000. Because the stock market bubble for technological companies burst, the fall was even
more  dramatic  in  the  US:  venture  capital  investment  in  2001  was  €  39.9  billion  (0.35%  of  GDP),
compared to € 95.1 billion one year earlier.

The fact that venture capital investment in the euro area takes place primarily at domestic level partly
reflects the importance for the capital providers to be close to their portfolio companies for the purpose
of monitoring their investments. It is equally plausible, however, that the pattern of internationalisation
of private equity management and investment is in part driven by differences in the regulatory, tax and
legal infrastructure of the EU countries. For instance, national regulations on whether pension funds
and  insurance  companies  are  allowed  to  invest  in  private  equity  still  differ  and  national  tax  system
impact differently on venture capital investments.

4.6

Financial intermediaries

The impact of financial integration has not been confined to the different financial market sections; it
has  also  extended  to  the  activities  of  financial  intermediaries.  European  banks  are  increasingly
involved in offering financial services to foreign businesses and individuals. The market for corporate
finance services in Europe is increasingly open to global competition. In some activities, such as bond
and equity issuance, as well as syndicated lending, domestic intermediaries have been loosing ground
with respect to US competitors. The introduction of the euro has further intensified competition among

24 For  instance,  the  clearing  functions  of  three  of  the  Euronext  exchanges  (Amsterdam,  Brussels  and  Paris)  have  legally
merged since the beginning of 2001 into Clearnet SBF as the central counterparty for all the transactions carried out on
Euronext.  To  facilitate  cross-border  transfer  of  securities,  links  between  security  settlement  systems  have  been
established. However, the use of these links has been more modest than expected. (ECB (2001) Payment and securities
settlement systems in the European Union (Blue Book)).

34

                                                
financial intermediaries by facilitating price transparency, by reducing foreign exchange revenues, by
eliminating the competitive advantage for domestic players associated with the existence of national
currencies  and  by  promoting  the  development  of  much  broader  and  more  liquid  securities  markets
which foster securitisation and disintermediation.

The most visible response of financial intermediaries to these pressures has been consolidation, either
through mergers and acquisitions or though cross-shareholdings. Consolidation has been accompanied
by  a  restructuring  process  and  a  reorientation  of  activities  from  “traditional”  bank  lending  towards
“investment  banking”  style  activities.  This  reorientation  in  banks’  activities  has    enhanced  financial
market intermediation by creating and selling new capital market products or advising clients on the
pricing and structuring of a merger or acquisition. As a result, there has been a shift in bank revenue
flows  from  interest  income  to  non-interest  income  (fees  and  commission),  and  reduced  reliance  on
deposits in favour of securities issuance. Yet, the decline in investment banking activities in 2001 has
underlined the need for the EU banking sector to enhance efficiency and profitability in traditional ban
king activities.

Consolidation  among  financial  intermediaries  has  so  far  taken  place  mainly  within  national
boundaries, implying a significant increase in industry concentration at the national level particularly
in the smaller Member States. The trend towards domestic conglomeration (i.e. consolidation across
financial  sectors)  is  also  increasing  in  many  parts  of  the  EU.  However,  cross-border  mergers  and
acquisitions have not been insignificant and have shown an increasing trend. Because the significant
differences in national legal and regulatory environments (e.g. consumer and competition laws) make
a  pan-European  product  range  impractical  at  present,  the  scale  and  scope  of  economies  from  cross-
border  mergers  would  seem  to  be  less  than  those  from  domestic  mergers.  Cultural  factors  and
differences  in  the  framework  for  corporate  governance  also  tend  to  discourage  cross-border
consolidation.  In  these  circumstances,  financial  intermediaries  may  prefer  to  engage  in  defensive
mergers at the domestic level in preparation for pan-European competition when integration of the EU
financial system is more advanced.

4.7

Challenges for policy-makers

The introduction of the euro, by largely reducing exchange rate risk within the EU and by acting as a
catalyst for reform, has been a main factor in speeding up integration. Even with the euro in place, the
objective of a single financial market – an objective that dates back to the early 1970s –still remains to
be  achieved.  While  financial  market  integration  is  to  a  large  extent  market-driven,  as  the  financial
institutions  themselves  take  advantage  of  the  opportunities  offered  by  financial  market  integration,
there is a need for public policy action in a range of areas.

The political support for policy has been growing over time as policy-makers increasingly recognise
the  economic  benefits  of  financial  integration.  In  an  integrated  market,  savers  and  investors  benefit
from  broader  choices  at  lower  transaction  costs.  At  the  macroeconomic  level,  this  translates  into
higher  saving,  investment,  productivity,  and  eventually  economic  growth.  These  effects  were
discussed recently in an EFC Report on Financial Integration to the Oviedo informal Ecofin Council
(13-14 April 2002). Successive European Councils (most recently the Barcelona European Council in
March 2002) have established the integration of EU financial markets as a priority of economic reform
in the EU.

35

This priority is reflected in a coherent policy strategy at EU level and in the urgency which has been
attributed to its implementation. First, and most importantly, the EU is committed to implementing the
Financial  Services  Action  Plan (FSAP)  _  a  package  of  42  policy  initiatives  aimed  at  improving  the
functioning of the  EU financial  system  –  by  2005.  An  even  tighter  deadline,  2003,  has  been  set  for
actions relating to securities markets and for the Risk Capital Action Plan (RCAP). The latter is the
blueprint  for  developing  an  integrated  and  efficient  market  for  equity  financing  of  young  and
innovative  businesses.  Second, the  implementation  of the  FSAP is  to  be  consistent  across  all  of  the
Member States so that there is effective – rather than just nominal - integration of national financial
markets.  The  new  decision-making  framework  for  securities  legislation, adopted  on  the  basis  of  the
proposals  by  the  Lamfalussy  Committee25  should  contribute  to  this  objective  and  ensure  that
legislation is more swiftly adapted to the evolving financial markets. Third, competition policy is to be
pro-active as financial integration proceeds, so as to ensure that economic benefits are fully exploited.
Fourth,  consumers  and  investors  are  to  be  adequately  protected  so  that  they  have  the  confidence  to
operate in, and enjoy the full benefits of a single market extending across the Union.

25 Committee of Wise Men on the Regulation of European Securities Markets. The Committee issued its Report in February
2001.  To  speed  up  and  facilitate  the  creation  of  an  EU  regulatory  framework  for  securities  markets,  the  Committee
proposes a new four-level approach to legislation:

(cid:1) 

(cid:1) 

(cid:1) 

(cid:1) 

Level 1 - the adoption of framework principles, as proposed by the Commission to the Council and European Parliament
for co-decision;

Level  2  -  the  adoption  of  implementing  legislation,  as prepared  by  the  Commission  with  the  assistance  of  a  new  EU
Securities  Committee  and  a  Committee  of  EU  Regulators;  the  European  Securities  Committee  would  be  created  to
resolve technical regulatory issues on a fast track basis to ensure their speedy adoption;

Level 3 - the consistent transposition of Level I and Level 2 legislation into national law on the basis of enhanced co-
operation among national securities regulators ;

Level  4  -  stricter  enforcement  of  legislation  by  the  Commission  with  Member  State  governments,  national  regulators
and the private sector.

The European Parliament gave its agreement to this approach on 5 February 2002.

36

                                                
5.

5.1

THE EURO AS AN INTERNATIONAL CURRENCY

Introduction

An international currency performs the traditional functions of money at an international level. It must
serve as a unit of account, a means of exchange and a store of value. As can be seen from the table
below, the  way  in  which a  currency  performs  these functions  differs  for the  private  and the  official
sector, but the private sector dominates the internationalisation of a currency due to its much bigger
size.

Principal uses of an international currency by the private and official sectors

Private sector

official sector

unit of account

Invoicing currency

anchor or reference currency
for exchange rate regimes

Quotation currency

means of exchange

Payment currency

intervention currency

Vehicle currency

store of value

Financing currency

reserve currency

Investment currency

The  US  dollar  is  still  the  leading  international  currency,  but  the  euro  became  the  world's  second
leading currency after its launch. There are a number of factors that support the use of the euro as an
international  currency.  The  first  is  the  size  of  the  euro-area  economy.  The  euro  area  accounts  for
approximately 16 % of world GDP, making it somewhat smaller than the US (21 %), but much larger
than Japan (8 %). Figures for the share of the three areas in total world trade in goods and services are
similar. The second factor which makes the euro attractive as an international currency is its stability,
which  reflects  the  sound  economic  fundamentals  in  the  euro  area,  underpinned  by  the  stability-
oriented  economic-policy  framework  under  EMU.  The  third  factor  is  the  ongoing  integration  of
national  financial  markets  in  Europe  into  broad,  deep  and  liquid  pan-European  financial  markets,
which will enhance the role of the euro in international borrowing and lending activity.

The history of the international monetary system includes periods when two currencies have competed
with each other as international currencies (sterling and the US dollar in the inter-war period). Because
network and scale effects drive the internationalisation of a currency, the US dollar is likely to remain
the dominant currency.  In  any  event,  the  process  of internationalisation  of the  euro  is  driven  by  the
private-sector.

5.2

International use of the euro by the private sector

The private use of a currency internationally as a unit of account can be seen in the invoicing of trade
and financial transactions and in quotations of commodity prices. Although there is little evidence on

37

invoicing, there is no doubt that the dollar remains the dominant currency for this purpose. In 2000,
prior to the introduction of euro notes and coins, the share of the euro in the invoicing of international
transactions was estimated to be between 15 % and 17 % of the total. Now that euro notes and coins
have  been  introduced,  however,  the  euro  is  likely  to  progressively  expand  its  role  as  an  invoicing
currency,  especially  at  regional  level.  The  increased  use  of  the  euro  for  invoicing  purposes  will  be
reinforced  by  the  historical  tendency  for  international  transactions  to  be  invoiced  in  the  exporter's
currency and by the large share of the euro-area in world trade. The dollar also remains the dominant
quotation  currency  for  commodities.  Although  there  are  some  commodity  futures  listed  in  Europe
which are priced in euro, their number remains limited for the time being.

The  private  use  of  a  currency  internationally  as  a  means  of  payment  is  reflected  in  its  usage  as  a
payment currency and as a vehicle currency in foreign exchange markets. As far as the euro's role as a
payment currency is concerned, the Commission's quarterly survey of banks in the euro area indicates
that the euro's share of international payments by euro-area residents increased very rapidly prior to its
launch, from 24 % in volume terms (36 % in value terms) in the third quarter of 2000 to nearly 40 %
(48 % in value terms) in the third quarter of 2001. With the launch of euro notes and coins and the
conversion  of  all  remaining  euro-area  accounts  into  euros,  the  share  of  the  euro  in  international
payments will no doubt increase still further.

A  currency's  use  as  a  vehicle  currency  (i.e.  as  a  means  of  exchanging  two  other  currencies)  in  the
foreign  exchange  markets  is  a  key  attribute  that  greatly  influences  its  attractiveness  as  a  means  of
performing the other functions of an international currency (e.g. a reserve currency). However, this is
also an area where inertia is very strong, as there are scale economies to be had from using just one
vehicle currency. At a global level, the US dollar remains the dominant vehicle currency as it benefits
from  direct  inter-bank  markets  with  all  other  currencies.  On  the  basis  of  available  information,  the
euro does not play a significant role as a global vehicle currency, although it has inherited a vehicle
currency role from the German mark at a regional level. However, the introduction of the euro has had
an impact on the currency composition of foreign exchange market activity by eliminating intra-euro-
area  trading  (see  box  below).  Figures  from  the  BIS  triennial  survey  of  foreign  exchange  market
activity published in October 2001 reveal that in April of  that  year  the  euro featured in  38 %  of  all
foreign  exchange  transactions  –  higher  than  the  mark's  share  in  1998  (30  %),  but  well  below  the
combined share of all euro legacy currencies (53 %) in that year.

When  the  private  sector  uses  a  currency  as  a  financing  currency  or  an  investment  currency,  this
reflects its function as an international store of value. A review of the international use of the euro by
the  ECB  published in  September  2001  indicates  that  it  is  now  the  second  most  important  financing
currency used at international level, with shares of between 22 % and 34 % depending on the financial
instrument and how it is measured. On the basis of the so-called narrow measure that includes  only
issuance by non-residents, the average share of the euro legacy currencies in bond and note issuance
was  19  %  in  the  period  1994-1998.  In  1999,  the  euro's  share  rose  to  34  %  on  average,  perhaps
reflecting  eagerness  on  the  part  of  major  issuers  to  establish  themselves  in  the  new  currency.  But
historically low euro interest rates, should also have increased the attractiveness of borrowing in euro
for foreign companies. Whilst there has been continued strong activity in euro-denominated securities
issuance  by  non-residents,  the  euro's  share  has  been  somewhat  volatile  since  its  1999  peak  bur
remained  at  a  high  level.  The  broad  measure  includes  issuance  by  euro-area  residents  aimed  at  the
international financial market. The euro has a higher share of the international issuance of bonds and
notes (38 % on average in 2000) if one uses the broad measure, because of the much lower share of
yen-denominated debt security issuance with international characteristics. There has also been a strong

38

increase in euro issuance in the international money market, which can be explained by an expected
and actual increase in liquidity resulting from the creation of an integrated euro money market.

The euro is also the second most important investment currency used at international level, although
information  on  the  assets  side  is  less  readily  available  than  on  the  liabilities  side.  The  ECB  review
reveals that the euro's share of international investments ranges from 22 % to 32 % depending on the
assets under consideration. It is highest for bond investments and lowest for international bank assets.

Box : The impact of the euro on foreign exchange markets

According  to  figures  from  the  BIS,  average  daily  turnover  in  traditional  foreign  exchange  markets  (i.e.  the
markets for spot transactions, forward transactions and foreign-exchange swaps) declined by 19 % between 1998
and  2001.  One  of  the  main  contributors  to  this  fall  in  turnover  was  the  introduction  of  the  euro  because  it
eliminated  trading  between  the  legacy  currencies  (the  other  factors  are  consolidation  in  both  the  banking  and
corporate  sectors  and  the  growing  share  of  electronic  brokering).  Trading  among  the  legacy  currencies  had
already  started  to  decline  well  ahead  of  the  start  of  Stage  Three  of  EMU.  Between  1995  and  1998,  trading
between the EMS currencies fell by some 5 % of global turnover. With the introduction of the euro on 1 January
1999 a further 6 % or so of total turnover was eliminated.

The decline in turnover was not reversed by any increase in trading in the euro compared to the legacy currencies
(see main text). Nevertheless, the BIS reports that the dollar/euro pair was by far the most traded currency pair in
2001,  accounting  for  some  30  %  of  global  turnover.  The  introduction  of  the  euro  initially  led  to  a  substantial
drop in market volumes in both spot and forward markets. In the forward market euro volumes fell by an initial
40  %  compared  to  previous  volumes  in  trades  involving  the  legacy  currencies.  Since  then,  however,  volumes
have  recovered  somewhat.  Consequently,  the  overall  decline  in  volumes  compared  to  the  period  before  the
launch of the euro is now around 25 %.

5.3

The international use of the euro by the official sector

Perhaps the most visible international usage of a currency by the official sector is in its function as a
unit  of  account.  The  euro  is  widely  used  as  an  anchor  or  reference  currency  in  the  exchange  rate
regimes of third countries. Over fifty countries have managed exchange rate arrangements that include
a  reference  to  the  euro,  either  in  isolation  or  in  conjunction  with  other  currencies.  The  type  of
arrangements  adopted  by  third  countries  range  from  currency  boards  to  managed  floating  policies.
Geographically, these countries are located mainly in Europe and Africa. The main motivating factors
behind  the  choice  of  the  euro  as  an  anchor  or  reference  currency  by  third  parties  are  the  extensive
trade, aid and financial linkages that these countries have with the economy of the euro area and, for
some countries, the EU accession process (see below).

An international currency can perform the function of a means of payment for the official sector. This
can be seen in the use of the currency for official intervention in foreign exchange markets. The dollar
enjoys dominant- but not exclusive -  use as an intervention currency at global level. The suitability of
the dollar as an intervention currency reflects its liquidity on foreign exchange markets. Nevertheless,
the euro has been used as  an intervention  currency  by  several  third  countries  at  regional  level.  This
usage of the euro is closely related to its role as an anchor currency. Euro-denominated intervention
most obviously occurs in the new exchange rate mechanism (ERM II), where EU Member States with
a derogation – currently only Denmark, but previously also Greece until the end of 2000 – link their
currencies to the euro.

39

Finally,  the  official  sector's  use  of  an  international  currency  as  a  store  of  value  can  be  seen  in  its
holdings  of  foreign  reserves.  Figures  from  the  latest  IMF  Annual  Report  show  that  the  US  dollar
remains the dominant reserve currency. At the end of 2000, the dollar accounted for 68 % of foreign
reserves. The euro is the second most important reserve currency after the dollar, accounting for 13 %
of  foreign  exchange  reserves.  The  share  of  the  euro  remained  virtually  unchanged  from  1999.
Adjusting the data to take into account only holdings of legacy currencies held outside the euro area,
the IMF Annual Report indicates that the combined share of these currencies in of total international
reserves in 1998 was virtually identical to the share of the euro in 1999 and 2000.

5.4

The candidate countries and adoption of the euro

The EC Treaty provides for a clear and unique institutional path for the adoption of the single currency
by the candidate countries. Upon accession, the new Member States will participate in EMU with the
status of Member States with a derogation from adopting the euro. This status will be granted in the
accession Treaties. New Member States will have to treat their exchange rate policies as a matter of
common  concern  and  are  expected  to  join  ERM  II  at  some  point  after  accession.  Then,  for  the
adoption of the euro, the Treaty requires that new Member States reach a high degree of sustainable
convergence. The equal treatment principle will be applied in full to the candidate countries. This path
excludes  both  adoption  of  the  euro  immediately  upon  accession,  and    adoption  of  the  euro  before
accession, sometimes referred to as “euroization”.

What are the  implications  for  economic  policy  in the candidate countries? The  key  message  is  that,
even  in  the  countries  where transition  is  most  advanced,  the  reform  agenda  for  accession  must  take
priority  over  policy  moves  inspired  by  the  prospect  of  EMU  participation.  Compliance  with  the
Copenhagen  criteria  takes  precedence  over  compliance  with  the  nominal  convergence  criteria,  and
therefore  EMU  participation,  for  at  least  two  reasons.  Firstly,  greater  progress  towards  real  and
structural  convergence  should  take  place  before  nominal  convergence,  although  the  two  can  be
mutually  supportive.  Secondly,  only  countries  that  are  functioning  market  economies  capable  of
coping  with  competitive  pressures  can  be  assessed  for  nominal  convergence.  In  other  words,  the
convergence criteria must be applied to “comparable economies”.

After  accession,  ERM  II  is  flexible  enough  to  accommodate  different  regimes,  provided  that  the
countries’ commitments and objectives are credible and in line with those of the mechanism. The only
clear incompatibilities vis-à-vis ERM  II that can already be identified at this stage are fully  floating
exchange rates, crawling pegs and pegs against anchors other than the euro. In principle, the option of
maintaining a euro-based currency board until the adoption of the euro is available on a case-by-case
basis,  as  an  additional  unilateral  commitment  to  a  greater  degree  of  fixity  against  the  euro,  within
ERM II. However, when a country with a currency board wants to join ERM II, the request will still
have to be examined in the context of the common procedure set out in ERM II Resolution, and the
central  parity/conversion  rate  will  have  to  be  agreed  multilaterally.  This  implies  that  some  of  the
countries  that  might  be  able  to  successfully  operate  a  currency  board  with  the  euro  would  not
necessarily  have  to  go  through  a  “double  regime  change”  (moving  away  to  some  flexibility  before
going back again to a harder peg and, subsequently, the irrevocable fixing of the exchange rate).

Generally speaking, the  candidate  countries  will have  to reconcile their  ambitions  for  exchange  rate
stability and inflation reduction in the run-up to accession and participation in the ERM II.

40

5.5

The euro area’s contribution to global policy coordination

The single monetary and exchange rate policies, accompanied by increased coordination of policies on
the fiscal and structural fronts, have significant implications for the economic relationship between the
euro  area  and  the  rest  of  the  world.  Monetary  and  exchange  rate  policies  have  become  exclusive
Community  competence;  financial  markets  in  Europe  are  being  progressively  integrated;  and  the
overall  policy  stance  of  the  euro  area  is  what  matters  for  the  rest  of  the  world  when  international  -
economic and fiscal issues are discussed.

International institutions in charge of multilateral surveillance, such as the IMF and the OECD, have
started to acknowledge the implications of these changes by assessing on a regular basis the overall
macro-economic stance of  the  euro  area. The change  is  also reflected  in  G7  Finance  Ministers’  and
Central Bank Governors’ statements which no longer refer to the macro-economic developments and
prospects of specific euro area Member States but to the overall euro area outlook.

Internal coordination on external positions

The EC Treaty sets out procedures, albeit  in very condensed form, for the Community to deal with the
international (institutional) aspects of EMU. Most of them are found in Article 111 (formerly Article
109).  Although  Article  111  is  a  procedural  article  and  is  clearly  a  compromise  between  different
viewpoints,  it  clearly  shows that  exchange  rate  policy  (i.e. formal  agreements  on  an  exchange  ratge
system and general orientations for exchange rate policy) are  a matter for the Council (with only the
“ins”  to  vote).  The  article  also  sets  out  the  procedure  to  be  used  by  the  Community  to  decide  its
position  to  be  used  in  international  discussions  on  “issues  of  particular  relevance  to  economic  and
monetary  union”.  The  same  article  prescribes  that  representation  of  the  Community  at  international
level  is  to  be  decided  unanimously  by  the  Council  on  the  basis  of  a  Commission  proposal  in
compliance with the allocation of powers laid down in Articles 99 and 105. It was thus expected that,
with  Stage Three  of  EMU,  Europe  would  assume  a  role  in  the  international  financial  and  monetary
system commensurate with its economic weight.

Since  1999,  practical  arrangements  have  been  devised  for  the  internal  coordination  of  external
positions. In particular, the Eurogroup/Ecofin have devoted much work establishing common positions
and  understandings.  These  positions  have  covered  a  wide  range  of  issues,  including  international
financial architecture, financing for development and the economic situation in the world or in various
key  countries.  They  provide  an  input  for  action  by  the  European  Executive  Directors  on  the  IMF
Board  and  guide  the  Presidency,  and  other  European  representatives,  during  international  meetings,
such as the International Monetary and Financial Committee (IMFC), G7 meetings and OECD/EDRC
consultations with the euro area..

While substantial progress has been made, various challenges still need to be addressed, such as how
to ensure that the agreement among Europeans on principles is implemented in practice. This would
mean,  for  example,  ensuring  that  the  European  common  views  on  the  need  for  private  sector
involvement are applied to specific crisis resolution cases. Also, common positions have to evolve and
be  adapted  by  drawing  on the lessons of  new  experiences  and/or  on  dialogue  with  our  international
partners. By the same token, there is scope for increasing the number of issues on which a common
position  could  be  taken in  order  for  Europe  to  develop  a  more  pro-active  and  consistent  role  in  the
international monetary and financial system. Finally, agreed European common positions have to be
communicated effectively to the relevant interlocutors.

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External representation of the euro area

These  challenges  are  closely  connected  to  the  external  representation  issue.  Different  European
Councils have dealt with the issue of international economic co-operation and external representation
(notably Luxembourg and Vienna), but no Council decision has yet been taken to legally underpin the
resulting  framework.  The  European  Council  conclusions,  moreover,  only  address  the  Community
representation in certain international gatherings. For the IMF, the Vienna conclusions stated that "The
ECB, as the Community body competent for monetary policy, should be granted an observer status at
the IMF board. The views of the European Community/EMU on other issues of particular relevance to
the  EMU  would  be  presented  at  the  IMF  board  by the  relevant  member  of  the  Executive  Director's
office  of  the  Member  State  holding  the  euro  Presidency,  assisted  by  a  representative  of  the
Commission."

For the G7, the Vienna Presidency conclusion stated that "The European Council endorses the report
of the Council on the external representation of the Community, which foresees that the President of
the ECOFIN Council, or if the President is from a non-euro area Member State, the President of the
Euro 11, assisted by the Commission, shall participate in meetings of the G7 (Finance)" In Annex II of
the  Conclusions,  it  was  noted  that  “the  President  of  the  ECB  attends  meetings  of  the  [G7]  for  the
discussion  which  relate  to  EMU,  e.g.  multilateral  surveillance,  exchange-rate  issues,  and  for
agreement of the relevant sections of the published Statement”.

In  actual  fact,  the  European  Council  conclusions  have  only  partially  been  implemented.  So  far,  the
Eurogroup Chairman and the ECB President attend only the session of the G7 Finance Ministers and
Central Bank Governors meetings relating to multilateral surveillance and exchange rate issues. Nor is
the participation of the Commission fully in line with these agreements.

Institutional changes within the IMF have also been limited. The ECB has obtained observer status on
the IMF Board and is allowed to attend Board meetings on issues of particular relevance for the euro
area.

Progress towards adequate European representation and a single European voice is hindered by several
factors.  Amongst  them  the  grouping  of  European  countries  in  IMF  constituencies  with  non-EU
countries and even the inclusion of some EU countries in a constituencies led by a non-EU countries.
Also, membership of the IMF is based upon the concept of “country”.

In conclusion, the EMU project is still in the making as regards the external side. But, on important
international issues, EMU has fostered a common European position-taking process. This allows the
Community  to  start  playing  an  international  role  commensurate  with  its  financial  and  economic
weight.  This  needs  to  be  complemented  by  further  progress  on  representation.  The  ad-hoc
arrangements  that  were  made  at  the  start  of  Stage  III  of  EMU  have  proven  to  be  useful,  but  only
partially  meet  the  expectations  for  a  unified  and  strong  European  presence  in  international  matters.
Because of the informal nature of the arrangements, their lack of formalisation, the lack of continuity
associated  with  them  and  the  constraints  inherent  in  informal  coordination,  they  do  not  allow  the
Community’s position to have its full impact on the discussions at international level.

Proper  representation  of  the  euro  area  in  international  organisations  could  significantly  improve
multilateral co-operation against the background of a financial world that seems to be moving towards
a  tri-polar  currency  system.  The  challenge  of  achieving  appropriate  representation  and  participation

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for  the  euro  area  in  international  decision  making  procedures  is  thus  a  significant  issue  for  non-
Europeans  as  well.  This  is  apparent  in  the  pressure  from  other  industrial  and  emerging  market
economies to streamline EU representation. Addressing this issue is a crucial challenge for EU policy-
makers, who have to ensure that the EU becomes an effective player in the pursuit of its own interests
on the international stage.

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